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• • • • • • • • • Levell CFA®Exam Welcome zyxwvutsrqponmlkihgfedcbaYWVUTSRQPONMLKJIGFEDCBA As the VP of Advanced Designations opportunity The Kaplan Way for Learning at Kaplan Schweser, I am pleased to have the to help you prepare for thewtsronlhfecUSI 2016 (FA® exam. Getting an early start on your study program is important prepare, practice, and perform for you to sufficiently on exam day. Proper planning will allow you to set aside enough time to master the Learning Outcome Statements (LOS) in the Levell curriculum. Now that you've received your Schweserblotes", here's how to get started: Step 1: Access Your Online Tools Visit www.schweser.com and log in to your online account using the button located in the top navigation bar. After logging in, select the appropriate level and proceed to the dashboard where you can access your online products. Step 2: Create a Study Plan Create a study plan with the Study Calendar (located on the Schweser dashboard) and fam iliarize you rself with your financial calculator. Check out our calculator videos in the Candidate Resource Library (also found on the dashboard). Step 3: Prepare and Practice Read your Schwesertlotes" Volumes 1-5 At the end of each reading, you can answer the Concept Checker questions for better understanding of the curriculum. Attend a Weekly Class Attend live classes online or take part in our live classroom courses in select cities around the world. Our expert faculty will guide you through the curriculum with a structured approach to help you prepare for the CFA®exam. The Schweser On-Oemand Video Lectures, in combination with the Weekly Class, offer a blended learning approach that covers every LOS in the CFAcurriculum. instruction packages to the right. Visit www.schweser.com/cfa (See our to order.) 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Put your skills and knowledge to the test and ) WindsorWeek''''* gain confidence before the exam. (See exam options to the right.) ) Live Schweser Mock Exam (offered in select cities worldwide) Again, thank you for trusting Kaplan Schweser with your CFA exam preparation! ) Live Online Schweser Mock Exam Sincerely, *Onlyrofed offered for Juneexam V <--V\.A./ Tim Smaby, PhD, (FA, FRM Vice President, Advanced Designations, Kaplan Schweser Contact us for questions about your study package, upgrading your package, purchasing 888.325.5072 (U.S.) 1+1608.779.8327 [email protected] I additional study materials, or for additional information: (Int'l.) www.sehweser.eom/efa MRKT-18934 BOOK 4 CORPORATE FINANCE, PORTFOLIO MANAGEMENT, AND EQUITY INVESTMENTS zyvutsrqponmlkigfedcaVSRPOMLKIEA Reading Assignments and Learning Outcome Statements v Study Session 11 - Corporate Finance 1 Self-Test - Corporate Finance 110 Study Session 12 - Portfolio Management 114 Self-Test - Portfolio Management 197 Study Session 13 - Equity: Market Organization, Market Indices, and Market Efficiency 200 Study Session 14 - Equity Analysis and Valuation 261 Self-Test - Equity Investments 323 ~()rIlllllasi ~~i7 Index ~32 ©20 15 Kaplan, Inc. Page iii i SCHWESERNOTESTM 2016 LEVEL I CFA® BOOK 4: CORPORATE FINANCE, PORTFOLIO MANAGEMENT, AND EQUITY INVESTMENTS ©20 15 Kaplan, Inc. All rights reserved. Published in 2015 by Kaplan, Inc. Printed in the United States of America. ISBN: 978-1-4754-3522-1 PPN: 3200-6834 If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation of global copyright laws. Your assistance in pursuing potential violators of this law is greatly appreciated. Required CFA Institute disclaimer: "CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan Schweser, CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute." Certain materials contained within this text are the copyrighted property of CFA Institute. The following is the copyright disclosure for these materials: "Copyright, 2015, CFA Institute. Reproduced and republished from 2016 Learning Outcome Statements, Level I, II, and III questions from CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute's Global Investment Performance Standards with permission from CFA Institute. All Rights Reserved." These materials may not be copied without written permission from the author. The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics. Your assistance in pursuing potential violators of this law is greatly appreciated. Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth by CFA Institute in their 2016 Level I CFA Study Guide. The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed to be accurate. However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success. The authors of the referenced readings have not endorsed or sponsored these Notes. Page iv ©2015 Kaplan, Inc. READING ASSIGNMENTS AND LEARNING OUTCOME STATEMENTS zywvutsrqponmlkihgfedcbaVTPOMIFECA The following material is a review of the Corporate Finance, Portfolio Management, and Equity Investments principles designed to address the learning outcome statements set forth by CFA Institute. Reading Assignments Corporate Finance, CFA Program Level 12016 Curriculum, Volume 4 (CFA Institute, 2015) 35. Capital Budgeting page 1 36. Cost of Capital page 24 37. Measures of Leverage page 49 38. Dividends and Share Repurchases: Basics page 64 39. Working Capital Management page 78 40. The Corporate Governance of Listed Companies: A Manual for Investors page 94 zywvutsrqponmlkihgfedcaWVTSRPOMLKIGFEDCBA STUDY SESSION 12 Reading Assignments Portfolio Management, CFA Program Level 12016 Curriculum, Volume 4 (CFA Institute, 2015) 41. Portfolio Management: An Overview page 114 42. Risk Management: An Introduction page 126 43. Portfolio Risk and Return: Part I page 137 44. Portfolio Risk and Return: Part II page 160 45. Basics of Portfolio Planning and Construction page 186 STUDY SESSION 13 Reading Assignments Equity: Market Organization, Market Indices, and Market Efficiency, CFA Program Level I 2016 Curriculum, Volume 5 (CFA Institute, 2015) 46. Market Organization and Structure 47. Security Market Indices 48. Market Efficiency STUDY SESSION page 200 page 229 page 248 14 Reading Assignments Equity Analysis and Valuation, CFA Program Level 12016 Curriculum, Volume 5 (CFA Institute, 2015) 49. Overview of Equity Securities page 261 50. Introduction to Industry and Company Analysis page 274 51. Equity Valuation: Concepts and Basic Tools page 294 ©20 15 Kaplan, Inc. Pagev Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Reading Assignments and Learning Outcome Statements LEARNING OUTCOME STATEMENTS (LOS)wvutsrponlihgfedcaTPICA The topical coverage corresponds with the following CPA Institute assigned reading: 35. Capital Budgeting The candidate should be able to: a. describe the capital budgeting process and distinguish among the various categories of capital projects. (page 1) b. describe the basic principles of capital budgeting. (page 2) c. explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing. (page 4) d. calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project. (page 4) e. explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods. (page 12) f. describe expected relations among an investment's NPY, company value, and share price. (page 15) f The topical coverage corresponds with the following CPA Institute assigned reading: 36. Cost of Capital The candidate should be able to: a. calculate and interpret the weighted average cost of capital (WACC) of a company. (page 24) b. describe how taxes affect the cost of capital from different capital sources. (page 24) c. describe the use of target capital structure in estimating WACC and how target capital structure weights may be determined. (page 26) d. explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget. (page 27) e. explain the marginal cost of capital's role in determining the net present value of a project. (page 28) f. calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach. (page 28) g. calculate and interpret the cost of noncallable, nonconvertible preferred stock. (page 29) h. calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yieldplus risk-premium approach. (page 30) • 1. calculate and interpret the beta and cost of capital for a project. (page 32) • J • describe uses of country risk premiums in estimating the cost of equity . (page 34) k. describe the marginal cost of capital schedule, explain why it may be upwardsloping with respect to additional capital, and calculate and interpret its breakpoints. (page 35) 1. explain and demonstrate the correct treatment of flotation costs. (page 37) eca Page vi ©2015 Kaplan, Inc. Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Reading Assignments and Learning Outcome StatementswvutsrponlihgfedcaT The topical coverage corresponds with the following CPA Institute assigned reading: 37. Measures of Leverage The candidate should be able to: a. define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk. (page 49) b. calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage. (page 50) c. analyze the effect of financial leverage on a company's net income and return on equity. (page 53) d. calculate the breakeven quantity of sales and determine the company's net income at various sales levels. (page 55) e. calculate and interpret the operating breakeven quantity of sales. (page 55) The topical coverage corresponds with the following CPA Institute assigned reading: 38. Dividends and Share Repurchases: Basics The candidate should be able to: a. describe regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on shareholders' wealth and a company's financial ratios. (page 64) b. describe dividend payment chronology, including the significance of declaration, holder-of-record, ex-dividend, and payment dates. (page 67) c. compare share repurchase methods. (page 68) d. calculate and compare the effect of a share repurchase on earnings per share when 1) the repurchase is financed with the company's excess cash and 2) the company uses debt to finance the repurchase. (page 68) e. calculate the effect of a share repurchase on book value per share. (page 71) f. explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders' wealth, all else being equal. (page 71) The topical coverage corresponds with the following CPA Institute assigned reading: 39. Working Capital Management The candidate should be able to: a. describe primary and secondary sources of liquidity and factors that influence a company's liquidity position. (page 78) b. compare a company's liquidity measures with those of peer companies. (page 79) c. evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company's effectiveness with that of peer companies. (page 81) d. describe how different types of cash flows affect a company's net daily cash position. (page 81) e. calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company's shortterm investment policy guidelines. (page 82) f. evaluate a company's management of accounts receivable, inventory, and accounts payable over time and compared to peer companies. (page 84) g. evaluate the choices of short-term funding available to a company and recommend a financing method. (page 87) ©20 15 Kaplan, Inc. Page vii Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Reading Assignments and Learning Outcome StatementswvutsrponlihgfedcaTPICA The topical coverage corresponds with the following CPA Institute assigned reading: 40. The Corporate Governance of Listed Companies: A Manual for Investors The candidate should be able to: a. define corporate governance. (page 94) b. describe practices related to board and committee independence, experience, compensation, external consultants, and frequency of elections and determine whether they are supportive of shareowner protection. (page 95) c. describe board independence and explain the importance of independent board members in corporate governance. (page 96) d. identify factors that an analyst should consider when evaluating the qualifications of board members. (page 96) e. describe responsibilities of the audit, compensation, and nominations committees and identify factors an investor should consider when evaluating the quality of each committee. (page 97) f. describe provisions that should be included in a strong corporate code of ethics. (page 99) g. evaluate, from a shareowner's perspective, company policies related to voting rules, shareowner sponsored proposals, common stock classes, and takeover defenses. (page 100) The topical coverage corresponds with the following CPA Institute assigned reading: 41. Portfolio Management: An Overview The candidate should be able to: a. describe the portfolio approach to investing. (page 114) b. describe types of investors and distinctive characteristics and needs of each. (page 115) c. describe defined contribution and defined benefit pension plans. (page 116) d. describe the steps in the portfolio management process. (page 117) e. describe mutual funds and compare them with other pooled investment products. (page 117) nA The topical coverage corresponds with the following CPA Institute assigned reading: 42. Risk Management: An Introduction The candidate should be able to: a. define risk management. (page 126) b. describe features of a risk management framework. (page 127) c. define risk governance and describe elements of effective risk governance. (page 127) d. explain how risk tolerance affects risk management. (page 127) e. describe risk budgeting and its role in risk governance. (page 128) f. identify financial and non-financial sources of risk and describe how they may interact. (page 128) g. describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods. (page 129) The topical coverage corresponds with the following CPA Institute assigned reading: 43. Portfolio Risk and Return: Part I The candidate should be able to: a. calculate and interpret major return measures and describe their appropriate uses. (page 137) b. describe characteristics of the major asset classes that investors consider in forming portfolios. (page 140) Page viii ©2015 Kaplan, Inc. Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Reading Assignments and Learning Outcome Statements c. d. e. f. g. h. calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data. (page 141) explain risk aversion and its implications for portfolio selection. (page 144) calculate and interpret portfolio standard deviation. (page 145) describe the effect on a portfolio's risk of investing in assets that are less than perfectly correlated. (page 146) describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio. (page 148) explain the selection of an optimal portfolio, given an investor's utility (or risk aversion) and the capital allocation line. (page 149) wvutsrponlihgfedcaTPICA The topical coverage corresponds with the following CPA Institute assigned reading: 44. Portfolio Risk and Return: Part II The candidate should be able to: a. describe the implications of combining a risk-free asset with a portfolio of risky assets. (page 160) b. explain the capital allocation line (CAL) and the capital market line (CML). (page 161) c. explain systematic and nonsystematic risk, including why an investor should not expect to receive additional return for bearing nonsystematic risk. (page 165) d. explain return generating models (including the market model) and their uses. (page 167) e. calculate and interpret beta. (page 168) f. explain the capital asset pricing model (CAPM), including its assumptions, and the security market line (SML). (page 170) g. calculate and interpret the expected return of an asset using the CAPM. (page 174) h. describe and demonstrate applications of the CAPM and the SML. (page 175) The topical coverage corresponds with the following CPA Institute assigned reading: 45. Basics of Portfolio Planning and Construction The candidate should be able to: a. describe the reasons for a written investment policy statement (IPS). (page 186) b. describe the major components of an IPS. (page 186) c. describe risk and return objectives and how they may be developed for a client. (page 187) d. distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor's financial risk tolerance. (page 188) e. describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets. (page 188) f. explain the specification of asset classes in relation to asset allocation. (page 190) g. describe the principles of portfolio construction and the role of asset allocation in relation to the IPS. (page 191) The topical coverage corresponds with the following CPA Institute assigned reading: 46. Market Organization and Structure The candidate should be able to: a. explain the main functions of the financial system. (page 200) b. describe classifications of assets and markets. (page 202) ©20 15 Kaplan, Inc. Page ix xi Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Reading Assignments and Learning Outcome Statements c. d. e. f f. g. h. • 1. • J• describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes. (page 203) describe types of financial intermediaries and services that they provide. (page 206) compare positions an investor can take in an asset. (page 209) calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call. (page 211) compare execution, validity, and clearing instructions. (page 212) compare market orders with limit orders. (page 212) define primary and secondary markets and explain how secondary markets support primary markets. (page 216) describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets. (page 217) describe characteristics of a well-functioning financial system. (page 219) describe objectives of market regulation. (page 220) wvutsrponlihgfedcaTPICA k. 1. eca The topical coverage corresponds with the following CPA Institute assigned reading: 47. Security Market Indices The candidate should be able to: a. describe a security market index. (page 229) b. calculate and interpret the value, price return, and total return of an index. (page 229) c. describe the choices and issues in index construction and management. (page 230) d. compare the different weighting methods used in index construction. (page 230) e. calculate and analyze the value and return of an index given its weighting method. (page 232) f. describe rebalancing and reconstitution of an index. (page 236) g. describe uses of security market indices. (page 237) h. describe types of equity indices. (page 237) • 1. describe types of fixed-income indices. (page 238) j. describe indices representing alternative investments. (page 239) k. compare types of security market indices. (page 240) The topical coverage corresponds with the following CPA Institute assigned reading: 48. Market Efficiency The candidate should be able to: a. describe market efficiency and related concepts, including their importance to investment practitioners. (page 248) b. distinguish between market value and intrinsic value. (page 249) c. explain factors that affect a market's efficiency. (page 249) d. contrast weak-form, semi-strong-form, and strong-form market efficiency. (page 250) e. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management. (page 251) f. describe market anomalies. (page 252) g. describe behavioral finance and its potential relevance to understanding market anomalies. (page 255) Page x ©2015 Kaplan, Inc. Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Reading Assignments and Learning Outcome StatementswvutsrponlihgfedcaT The topical coverage corresponds with the following CPA Institute assigned reading: 49. Overview of Equity Securities The candidate should be able to: a. describe characteristics of types of equity securities. (page 261) b. describe differences in voting rights and other ownership characteristics among different equity classes. (page 262) c. distinguish between public and private equity securities. (page 263) d. describe methods for investing in non-domestic equity securities. (page 264) e. compare the risk and return characteristics of different types of equity securities. (page 265) f. explain the role of equity securities in the financing of a company's assets. (page 266) g. distinguish between the market value and book value of equity securities. (page 266) h. compare a company's cost of equity, its (accounting) return on equity, and investors' required rates of return. (page 267) The topical coverage corresponds with the following CPA Institute assigned reading: 50. Introduction to Industry and Company Analysis The candidate should be able to: a. explain uses of industry analysis and the relation of industry analysis to company analysis. (page 274) b. compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system. (page 274) c. explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as "growth," "defensive," and "cyclical". (page 277) d. explain how a company's industry classification can be used to identify a potential "peer group" for equity valuation. (page 278) e. describe the elements that need to be covered in a thorough industry analysis. (page 279) f. describe the principles of strategic analysis of an industry. (page 279) g. explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition. (page 281) h. describe industry life cycle models, classify an industry as to life cycle stage, and describe limitations of the life-cycle concept in forecasting industry performance. (page 283) • 1. compare characteristics of representative industries from the various economic sectors. (page 285) J • describe macroeconomic, technological, demographic, governmental, and social influences on industry growth, profitability, and risk. (page 285) k. describe the elements that should be covered in a thorough company analysis. (page 286) f • eca The topical coverage corresponds with the following CPA Institute assigned reading: 51. Equity Valuation: Concepts and Basic Tools The candidate should be able to: a. evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market. (page 294) b. describe major categories of equity valuation models. (page 295) ©20 15 Kaplan, Inc. Page xi Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Reading Assignments and Learning Outcome Statements c. d. e. f f. g. h. • 1. • J• k. explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models. (page 296) calculate the intrinsic value of a non-callable, non-convertible preferred stock. (page 299) calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate. (page 300) identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate. (page 305) explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables. (page 306) calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value. (page 306) describe enterprise value multiples and their use in estimating equity value . (page 311) describe asset-based valuation models and their use in estimating equity value . (page 312) explain advantages and disadvantages of each category of valuation model. (page 314) ec Page xii ©2015 Kaplan, Inc. The following is a review of the Corporate Finance principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #35.UTPNLIGEDCBA CAPITAL BUDGETING Study Session 11 EXAM Focus If you recollect little from your basic financial management course in college (or if you didn't take one), you will need to spend some time on this review and go through the examples quite carefully. To be prepared for the exam, you need to know how to calculate all of the measures used to evaluate capital projects and the decision rules associated with them. Be sure you can interpret an NPV profile; one could be given as part of a question. Finally, know the reasoning behind the facts that (1) IRR and NPV give the same accept/reject decision for a single project and (2) IRR and NPV can give conflicting rankings for mutually exclusive projects. LOS 35.a: Describe the capital budgeting process and distinguish among the various categories of capital projects. zyutsrponmljigedcaVSPIFCA CFA ® Program Curriculum, Volume 4, page 6 The capital budgeting process is the process of identifying and evaluating capital projects, that is, projects where the cash flow to the firm will be received over a period longer than a year. Any corporate decisions with an impact on future earnings can be examined using this framework. Decisions about whether to buy a new machine, expand business in another geographic area, move the corporate headquarters to Cleveland, or replace a delivery truck, to name a few, can be examined using a capital budgeting analysis. For a number of good reasons, capital budgeting may be the most important responsibility that a financial manager has. First, because a capital budgeting decision often involves the purchase of costly long-term assets with lives of many years, the decisions made may determine the future success of the firm. Second, the principles underlying the capital budgeting process also apply to other corporate decisions, such as working capital management and making strategic mergers and acquisitions. Finally, making good capital budgeting decisions is consistent with management's primary goal of maximizing shareholder value. The capital budgeting process has four administrative steps: Step 1: Idea generation. The most important step in the capital budgeting process is generating good project ideas. Ideas can come from a number of sources including senior management, functional divisions, employees, or sources outside the company. Step 2: Analyzing project proposals. Because the decision to accept or reject a capital project is based on the project's expected future cash flows, a cash flow forecast must be made for each product to determine its expected profitability. ©20 15 Kaplan, Inc. Page 1 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital BudgetingyxwvutsrponmlkjihgfedcbaVSRPONMEDCA Step 3: Create the firm-wide capital budget. Firms must prioritize profitable projects according to the timing of the project's cash flows, available company resources, and the company's overall strategic plan. Many projects that are attractive individually may not make sense strategically. Step 4: Monitoring decisions and conducting a post-audit. It is important to follow up on all capital budgeting decisions. An analyst should compare the actual results to the projected results, and project managers should explain why projections did or did not match actual performance. Because the capital budgeting process is only as good as the estimates of the inputs into the model used to forecast cash flows, a post-audit should be used to identify systematic errors in the forecasting process and improve company operations. Categories of Capital Budgeting Projects Capital budgeting projects may be divided into the following categories: • • • • • • Replacement projects to maintain the business are normally made without detailed analysis. The only issues are whether the existing operations should continue and, if so, whether existing procedures or processes should be maintained. Replacement projects for cost reduction determine whether equipment that is obsolete, but still usable, should be replaced. A fairly detailed analysis is necessary in this case. Expansion projects are taken on to grow the business and involve a complex decision-making process because they require an explicit forecast of future demand. A very detailed analysis is required. New product or market development also entails a complex decision-making process that will require a detailed analysis due to the large amount of uncertainty involved. Mandatory projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. These projects typically generate little to no revenue, but they accompany new revenueproducing projects undertaken by the company. Other projects. Some projects are not easily analyzed through the capital budgeting process. Such projects may include a pet project of senior management (e.g., corporate perks) or a high-risk endeavor that is difficult to analyze with typical capital budgeting assessment methods (e.g., research and development projects). LOS 35.b: Describe the basic principles of capital budgeting. CPA ® Program Curriculum, Volume 4, page 8 The capital budgeting process involves five key principles: 1. Decisions are based on cashflows, not accounting income. The relevant cash flows to consider as part of the capital budgeting process are incremental cash flows, the changes in cash flows that will occur if the project is undertaken. Sunk costs are costs that cannot be avoided, even if the project is not undertaken. Because these costs are not affected by the accept/reject decision, they should not be included in the analysis. An example of a sunk cost is a consulting fee paid to a nA Page 2 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting marketing research firm to estimate demand for a new product prior to a decision on the project. Externalities are the effects the acceptance of a project may have on other firm cash flows. The primary one is a negative externality called cannibalization, which occurs when a new project takes sales from an existing product. When considering externalities, the full implication of the new project (loss in sales of existing products) should be taken into account. An example of cannibalization is when a soft drink company introduces a diet version of an existing beverage. The analyst should subtract the lost sales of the existing beverage from the expected new sales of the diet version when estimated incremental project cash flows. A positive externality exists when doing the project would have a positive effect on sales of a firm's other product lines. nA A project has a conventional cash flow pattern if the sign on the cash flows changes only once, with one or more cash outflows followed by one or more cash inflows. An unconventional cash flow pattern has more than one sign change. For example, a project might have an initial investment outflow, a series of cash inflows, and a cash outflow for asset retirement costs at the end of the project's life. zyxwutsrqponmljihgfedcbaTFC 2. Cashflows are based on opportunity costs. Opportunity costs are cash flows that a firm will lose by undertaking the project under analysis. These are cash flows generated by an asset the firm already owns that would be forgone if the project under consideration is undertaken. Opportunity costs should be included in project costs. For example, when building a plant, even if the firm already owns the land, the cost of the land should be charged to the project because it could be sold if not used. 3. The timing of cashflows is important. Capital budgeting decisions account for the time value of money, which means that cash flows received earlier are worth more than cash flows to be received later. 4. Cashflows are analyzed on an after-tax basis. The impact of taxes must be considered when analyzing all capital budgeting projects. Firm value is based on cash flows they get to keep, not those they send to the government. 5. Financing costsare reflected in the project's required rate of return. Do not consider financing costs specific to the project when estimating incremental cash flows. The discount rate used in the capital budgeting analysis takes account of the firm's cost of capital. Only projects that are expected to return more than the cost of the capital needed to fund them will increase the value of the firm. ©20 15 Kaplan, Inc. Page 3 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting LOS 35.c: Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital • • rationmg. utrponmligecaVPCA CPA ® Program Curriculum, Volume 4, page 9 Independent vs. Mutually Exclusive Projects Independent projects are projects that are unrelated to each other and allow for each project to be evaluated based on its own profitability. For example, if projects A and B are independent, and both projects are profitable, then the firm could accept both projects. Mutually exclusive means that only one project in a set of possible projects can be accepted and that the projects compete with each other. If projects A and B were mutually exclusive, the firm could accept either Project A or Project B, but not both. A capital budgeting decision between two different stamping machines with different costs and output would be an example of choosing between two mutually exclusive projects. Project Sequencing Some projects must be undertaken in a certain order, or sequence, so that investing in a project today creates the opportunity to invest in other projects in the future. For example, if a project undertaken today is profitable, that may create the opportunity to invest in a second project a year from now. However, if the project undertaken today turns out to be unprofitable, the firm will not invest in the second project. Unlimited Funds vs. Capital Rationing If a firm has unlimited access to capital, the firm can undertake all projects with expected returns that exceed the cost of capital. Many firms have constraints on the amount of capital they can raise and must use capital rationing. If a firm's profitable project opportunities exceed the amount of funds available, the firm must ration, or prioritize, its capital expenditures with the goal of achieving the maximum increase in value for shareholders given its available capital. LOS 35.d: Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project. CPA ® Program Curriculum, Volume 4, page 10 Net Present Value (NPV) We first examined the calculation of net present value (NPV) in Quantitative Methods. The NPV is the sum of the present values of all the expected incremental cash flows if a project is undertaken. The discount rate used is the firm's cost of Page 4 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting capital, adjusted for the risk level of the project. For a normal project, with an initial cash outflow followed by a series of expected after-tax cash inflows, the NPV is the present value of the expected inflows minus the initial cost of the project. CF1 NPV = CFo + (l+k)l CF2 CFn + + + (1+k)2 ... (l+k)n toB L: n CFt = t=o(l+k)t where: CFo = initial investment outlay (a negative cash flow) CF t = after-tax cash flow at time t k = required rate of return for project utsrponljiedcaYVPNBA A positive NPV project is expected to increase shareholder wealth, a negative NPV project is expected to decrease shareholder wealth, and a zero NPV project has no expected effect on shareholder wealth. For independent projects, the NPV decision rule is simply to accept any project with a positive NPV and to reject any project with a negative NPV. Example: NPV analysis Using the project cash flows presented in Table 1, compute the NPV of each project's cash flows and determine for each project whether it should be accepted or rejected. Assume that the cost of capital is 100/0. Table 1: Expected Net After-Tax Cash Flows Year {t) o Project A -$2,000 Project B -$2,000 1 1,000 200 2 800 600 3 600 800 4 200 1,200 Answer: NPV A = -2,000 + 1,000 + 800 + 600 + 200 = $157.64 (1.1)1 (1.1)2 (1.1)3 (1.1)4 NPV B = -2,000 + 200 + (1.1)1 600 + 800 + 1,200 = $98.36 (1.1)2 (1.1)3 (1.1)4 Both Project A and Project B have positive NPVs, so both should be accepted. You may calculate the NPV directly by using the cash flow (CF) keys on your calculator. The process is illustrated in Table 2 and Table 3 for Project A. ©20 15 Kaplan, Inc. Page 5 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital BudgetingWROKIA • Table 2: Calculating NPVA With the TI Business Analyst II Plus Key Strokes Explanation [CF] [2nd] [CLR WORK] Clear memory registers [+1-] [ENTER] 2,000 yxtsrponlkieaSKED Display CFO Initial cash outlay CFO [1] 1,000 [ENTER] Period 1 cash flow COl [1] Frequency of cash flow 1 [1] 800 [ENTER] Period 2 cash flow [1] Frequency of cash flow 2 [1] 600 [ENTER] Period 3 cash flow [1] Frequency of cash flow 3 [1] 200 [ENTER] Period 4 cash flow [1] Frequency of cash flow 4 [NPV] 10 [ENTER] [1] 10% discount rate Calculate NPV [CPT] = 0.00000 -2,000.00000 = = 1,000.00000 FO1 = 1.00000 C02 F02 C03 F03 C04 F04 800.00000 = = 1.00000 600.00000 = = 1.00000 200.00000 = = 1.00000 1= 10.00000 NPV = 157.63951 Table 3: Calculating NPVA With the HP12C I Key Strokes Explanation Display [f1-+[FIN] -+ [f1 -+ [REG] Clear memory registers 0.00000 [f] [5] Display 5 decimals. You only need to do this once. 0.00000 Initial cash outlay -2,000.00000 1,000 [g] [CFj] Period 1 cash flow 1,000.00000 800 [g] [CFj] Period 2 cash flow 800.00000 600 [g] [CFj] Period 3 cash flow 600.00000 200 [g] [CFj] Period 4 cash flow 200.00000 10 [i] 100/0discount rate 10.00000 [f] [NPV] Calculate NPV 157.63951 2,000 [CHS] [g] [CFO] Internal Rate of Return (IRR) For a normal project, the internal rate of return (IRR) is the discount rate that makes the present value of the expected incremental after-tax cash inflows just equal to the initial cost of the project. More generally, the IRR is the discount rate that makes the Page 6 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting present values of a project's estimated cash inflows equal to the present value of the project's estimated cash outflows. That is, IRR is the discount rate that makes the following relationship hold: PV (inflows) = PV (outflows) The IRR is also the discount rate for which the NPV of a project is equal to zero: To calculate the IRR, you may use the trial-and-error method. That is, just keep guessing IRRs until you get the right one, or you may use a financial calculator. usronliedcRI IRR decision rule: First, determine the required rate of return for a given project. This is usually the firm's cost of capital. Note that the required rate of return may be higher or lower than the firm's cost of capital to adjust for differences between project risk and the firm's average project risk. If IRR > the required rate of return, accept the project. If IRR < the required rate of return, reject the project. Example: IRR RI Continuing with the cash flows presented in Table 1 for projects A and B, compute the IRR for each project and determine whether to accept or reject each project under the assumptions that the projects are independent and that the required rate of return is 100/0. Answer: The cash flows should be entered as in Table 2 and Table 3 (if you haven't changed them, they are still there from the calculation of NPV). With the TI calculator, the IRR can be calculated with: [IRR] [CPT] to get 14.4888(0/0) for Project A and 11.7906(0/0) for Project B. ©20 15 Kaplan, Inc. Page 7 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting With the HP12C, the IRR can be calculated with: [f] [IRR] Both projects should be accepted because their IRRs are greater than the 10% required rate of return. Payback Period The payback period (PBP) is the number of years it takes to recover the initial cost of • an Investment. unBA Example: Payback period Calculate the payback periods for the two projects that have the cash flows presented in Table 1. Note the Year 0 cash How represents the initial cost of each project. Answer: Note that the cumulative net cash How (NCF) is just the running total of the cash flows at the end of each time period. Payback will occur when the cumulative NCF equals zero. To find the payback periods, construct Table 4. Table 4: Cumulative Net Cash Flows o Year (t) Project A Project B treaY Net cash flow -2,000 Cumulative NCF -2,000 Net cash flow -2,000 Cumulative NCF -2,000 The payback period is determined 1 1,000 -1,000 200 -1,800 2 3 4 800 600 200 -200 400 600 600 800 1,200 -400 800 -1,200 o from the cumulative net cash How table as follows: . d full ·1 unrecovered cost at the beginning of last year pay b ack perlO = years unn recovery + -----------=-_____:"'------:..__cash flow during the last year payback period A = 2 + 200 = 2.33 years 600 payback period B = 3 + 400 1200 Page 8 = 3.33 years ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting Because the payback period is a measure of liquidity, for a firm with liquidity concerns, the shorter a project's payback period, the better. However, project decisions should not be made on the basis of their payback periods because of the method's drawbacks. The main drawbacks of the payback period are that it does not take into account either the time value of money or cash flows beyond the payback period, which means terminal or salvage value wouldn't be considered. These drawbacks mean that the payback period is useless as a measure of profitability. The main benefit of the payback period is that it is a good measure of project liquidity. Firms with limited access to additional liquidity often impose a maximum payback period and then use a measure of profitability, such as NPV or IRR, to evaluate projects that satisfy this maximum payback period constraint. ywvutsrqponmlkjihgfedcbaYVTPONIFDB Professor's Note: If you have the Professional model of the TI calculator, you can easily calculate the payback period and the discounted payback period (which follows). Once NPV is displayed, use the down arrow to scroll through NFV (net future value), to PB (payback), and DPB (discounted payback). You must use the compute key when "PB=))is displayed. If the annual net cashflows are equal, the payback period is simply project cost divided by the annual cashflow. fI Discounted Payback Period The discounted payback period uses the present values of the project's estimated cash flows. It is the number of years it takes a project to recover its initial investment in present value terms and, therefore, must be greater than the payback period without discounting. Example: Discounted payback method Compute the discounted payback period for projects A and B described in Table 5. Assume that the firm's cost of capital is 100/0 and the firm's maximum discounted payback period is four years. Project B Net Cash Flow -2,000 200 600 800 1,200 Discounted NCF -2,000 182 496 601 820 Cumulative DNCF -2,000 -1,322 -721 99 -1,818 ©20 15 Kaplan, Inc. Page 9 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting Answer: 429 discounted payback A = 2 + -= 2.95 years 451 oFC discounted payback B = 3 + 721 = 3.88 years 820 The discounted payback period addresses one of the drawbacks of the payback period by discounting cash flows at the project's required rate of return. However, the discounted payback period still does not consider any cash flows beyond the payback period, which means that it is a poor measure of profitability. Again, its use is primarily as a measure of liquidity. Profitability Index (PI) The profitability index (PI) is the present value of a project's future cash flows divided by the initial cash outlay: PI = PV of future cash flows = 1 + NPV CFo CFo The profitability index is related closely to net present value. The NPV is the difference between the present value of future cash flows and the initial cash outlay, and the PI is the ratio of the present value of future cash flows to the initial cash outlay. If the NPV of a project is positive, the PI will be greater than one. If the NPV is negative, the PI will be less than one. It follows that the decision rule for the PI is: usronliedc If PI > 1.0, accept the project. If PI < 1.0, reject the project. Page 10 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting Example: Profitability index Going back to our original example, calculate the PI for projects A and B. Note that Table 1 has been reproduced as Table 6. BA Table 6: Expected Net After-Tax Cash Flows Year {t) Project A yxwvutsrqponmlkjihgfedcbaYVTRPNIDBA Project B a -$2,000 -$2,000 1 1,000 200 2 800 600 3 600 800 4 200 1,200 Answer: PV future cash flowsA = 1,000 1 (1.1) + 800 2 (1.1) + 600 3 (1.1) + 200 4 = $2,157.64 (1.1) = $2,157.64 = 1.079 PI A $2,000 PV future cash flowsg = 200 1 (1.1) + 600 2 (1.1) + 800 3 (1.1) + 1,200 4 = $2,098.36 (1.1) = $2,098.36 = 1.049 PI B $2,000 Decision: If projects A and B are independent, PI > 1 for both projects. accept both projects because Professor's Note: The accept/reject decision rule here is exactly equivalent to both the NPVand IRR decision rules. That is, if PI> 1, then the NPV must be positive, and the IRR must be greater than the discount rate. Note also that once you have the NPV; you can just add back the initial outlay to get the PVof the cash inflows used here. Recall that the NPV of Project B is $98.36 with an initial cost of $2, 000. PI is simply (2,000 + 98.36) / 2000. if ©20 15 Kaplan, Inc. Page 11 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting LOS 35.e: Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods. urpomligecaVPFCA CFA ® Program Curriculum, Volume 4, page 16 A project's NPV profile is a graph that shows a project's NPV for different discount rates. The NPV profiles for the two projects described in the previous example are presented in Figure 1. The project NPVs are summarized in the table below the graph. The discount rates are on the x-axis of the NPV profile, and the corresponding NPV s are plotted on the y-axis. Figure 1: NPV Profiles NPVBA ($) »> Project B's NPV Profile Project N.s NPV Profile _____ Crossover Rate 5 Discount Rate 00/0 50/0 100/0 150/0 NPVA 600.00 360.84 157.64 (16.66) NPVB 800.00 413.00 98.36 (160.28) Note that the projects' IRRs are the discount rates where the NPV profiles intersect the x-axis, because these are the discount rates for which NPV equals zero. Recall that the IRR is the discount rate that results in an NPV of zero. Also notice in Figure 1 that the NPV profiles intersect. They intersect at the discount rate for which NPVs of the projects are equal, 7.20/0. This rate at which the NPVs are equal is called the crossover rate. At discount rates below 7.20/0 (to the left of the intersection), Project B has the greater NPV, and at discount rates above 7.20/0, Project A has a greater NPV. Clearly, the discount rate used in the analysis can determine which one of two mutually exclusive projects will be accepted. Page 12 ©20 15 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned ReadinglX #35 - Capital Budgeting The NPV profiles for projects A and B intersect because of a difference in the timing of the cash flows. Examining the cash flows for the projects (Table 1), we can see that the total cash inflows for Project B are greater ($2,800) than those of Project A ($2,600). Because they both have the same initial cost ($2,000) at a discount rate of zero, Project B has a greater NPV (2,800 - 2,000 :;:$800) than Project A (2,600 2,000 :;:$600). We can also see that the cash flows for Project B come later in the project's life. That's why the NPV of Project B falls faster than the NPV of Project A as the discount rate increases, and the NPVs are eventually equal at a discount rate of7.20/0. At discount rates above 7.20/0, the fact that the total cash flows of Project B are greater in nominal dollars is overridden by the fact that Project B's cash flows come later in the project's life than those of Project A. Example: Crossover rate Two projects have the following cash flows: 20Xl 20X2 20X3 20X4 -550 -300 150 300 450 50 200 300 Project A Project B What is the crossover rate for Project A and Project B? Answer: The crossover rate is the discount rate that makes the NPVs of Projects A and B equal. That is, it makes the NPV of the differences between the two projects' cash flows equal zero. wtsrnifedcb To determine the crossover rate, subtract the cash flows of Project B from those of Project A and calculate the IRR of the differences. Project A - Project B CFO:;: -250; CFl 20Xl 20X2 20X3 20X4 -250 100 100 150 = 100; CF2 = 100; CF3 = 150; CPT IRR = 17.50/0 The Relative Advantages and Disadvantages of the NPV and IRR Methods A key advantage of NPV is that it is a direct measure of the expected increase in the value of the firm. NPV is theoretically the best method. Its main weakness is that it does not include any consideration of the size of the project. For example, an NPV of $100 is great for a project costing $100 but not so great for a project costing $1 million. ©20 15 Kaplan, Inc. Page 13 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting A key advantage of IRR is that it measures profitability as a percentage, showing the return on each dollar invested. The IRR provides information on the margin of safety that the NPV does not. From the IRR, we can tell how much below the IRR (estimated return) the actual project return could fall, in percentage terms, before the project becomes uneconomic (has a negative NPV). The disadvantages of the IRR method are (1) the possibility of producing rankings of mutually exclusive projects different from those from NPV analysis and (2) the possibility that a project has multiple IRRs or no IRR. vtsronlkjigfedcaYXRPC Conflicting Project Rankings Consider two projects with an initial investment of €1,000 and a required rate of return of 100/0.Project X will generate cash inflows of €500 at the end of each of the next five years. Project Y will generate a single cash flow of €4,000 at the end of the fifth year. Year 0 Project X Project Y -€1,000 -€1,000 1 500 0 2 500 0 3 500 0 4 500 0 5 500 4,000 NPV €895 €1,484 IRR 41.00/0 32.0% Project X has a higher IRR, but Project Y has a higher NPV. Which is the better project? If Project X is selected, the firm will be worth €895 more because the PV of the expected cash flows is €895 more than the initial cost of the project. Project Y, however, is expected to increase the value of the firm by €1,484. Project Y is the better project. Because NPV measures the expected increase in wealth from undertaking a project, NPV is the only acceptable criterion when ranking projects. Another reason, besides cash flow timing differences, that NPV and IRR may give conflicting project rankings is differences in project size. Consider two projects, one with an initial outlay of $100,000, and one with an initial outlay of $1 million. The smaller project may have a higher IRR, but the increase in firm value (NPV) may be small compared to the increase in firm value (NPV) of the larger project, even though its IRR is lower. It is sometimes said that the NPV method implicitly assumes that project cash flows can be reinvested at the discount rate used to calculate NPV. This is a realistic assumption, because it is reasonable to assume that project cash flows could be used to reduce the firm's capital requirements. Any funds that are used to reduce the firm's capital requirements allow the firm to avoid the cost of capital on those funds. Just by reducing its equity capital and debt, the firm could "earn" its cost of capital on funds Page 14 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting used to reduce its capital requirements. If we were to rank projects by their IRRs, we would be implicitly assuming that project cash flows could be reinvested at the project's IRR. This is unrealistic and, strictly speaking, if the firm could earn that rate on invested funds, that rate should be the one used to discount project cash flows. utsrponmlihgedcbaVTRPNMICA The "Multiple IRR" and "No IRR" Problems If a project has cash outflows during its life or at the end of its life in addition to its initial cash outflow, the project is said to have an unconventional cash flow pattern. Projects with such cash flows may have more than one IRR (there may be more than one discount rate that will produce an NPV equal to zero). It is also possible to have a project where there is no discount rate that results in a zero NPY, that is, the project does not have an IRR. A project with no IRR may actually be a profitable project. The lack of an IRR results from the project having unconventional cash flows, where mathematically, no IRR exists. NPV does not have this problem and produces theoretically correct decisions for projects with unconventional cash flow patterns. Neither of these problems can arise with the NPV method. If a project has nonnormal cash flows, the NPV method will give the appropriate accept/reject decision. LOS 35.£: Describe expected relations among an investment's NPV, company value, and share price. CPA ® Program Curriculum, Volume 4, page 25 Because the NPV method is a direct measure of the expected change in firm value from undertaking a capital project, it is also the criterion most related to stock prices. In theory, a positive NPV project should cause a proportionate increase in a company's stock price. ©20 15 Kaplan, Inc. Page 15 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting Example: Relationship between NPV and stock price Presstech is investing $500 million in new printing equipment. The present value of the future after-tax cash flows resulting from the equipment is $750 million. Presstech currently has 100 million shares outstanding, with a current market price of $45 per share. Assuming that this project is new information and is independent of other expectations about the company, calculate the effect of the new equipment on the value of the company and the effect on Presstech's stock price. Answer: NPV of the new printing equipment project = $750 million - $500 million = $250 million. Value of company prior to new equipment project share = $4.5 billion. = 100 million shares x $45 per Value of company after new equipment project = $4.5 billion + $250 million = $4.75 billion. Price per share after new equipment project = $4.75 billion / 100 million shares = $47.50. The stock price should increase from $45.00 per share to $47.50 per share as a result of the project. In reality, the impact of a project on the company's stock price is more complicated than the previous example. A company's stock price is a function of the present value of its expected future earnings stream. As a result, changes in the stock price will result more from changes in expectations about a firm's positive NPV projects. If a company announces a project for which managers expect a positive NPV but analysts expect a lower level of profitability from the project than the company does (e.g., an acquisition), the stock price may actually drop on the announcement. As another example, a project announcement may be taken as a signal about other future capital projects, raising expectations and resulting in a stock price increase that is much greater than what the NPV of the announced project would justify. xtsponieca Page 16 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting LOS 35.a Capital budgeting is the process of evaluating capital projects, projects with cash flows over more than one year. The four steps of the capital budgeting process are: (1) Generate investment ideas; (2) Analyze project ideas; (3) Create firm-wide capital budget; and (4) Monitor decisions and conduct a post-audit. Categories of capital projects include: (1) Replacement projects for maintaining the business or for cost reduction; (2) Expansion projects; (3) New product or market development; (4) Mandatory projects to meet environmental or regulatory requirements; (5) Other projects, such as research and development or pet projects of senior management. LOS 35.b Capital budgeting decisions should be based on incremental after-tax cash flows, the expected differences in after-tax cash flows if a project is undertaken. Sunk (already incurred) costs are not considered, but externalities and cash opportunity costs must be included in project cash flows. LOS 35.c Acceptable independent projects can all be undertaken, while a firm must choose between or among mutually exclusive projects. Project sequencing concerns the opportunities for future capital projects that may be created by undertaking a current project. If a firm cannot undertake all profitable projects because of limited ability to raise capital, the firm should choose that group of fundable positive NPV projects with the highest total NPV. LOS 35.d NPV is the sum of the present values of a project's expected cash flows and represents the increase in firm value from undertaking a project. Positive NPV projects should be undertaken, but negative NPV projects are expected to decrease the value of the firm. The IRR is the discount rate that equates the present values of the project's expected cash inflows and outflows and, thus, is the discount rate for which the NPV of a project is zero. A project for which the IRR is greater (less) than the discount rate will have an NPV that is positive (negative) and should be accepted (not be accepted). The payback (discounted payback) period is the number of years required to recover the original cost of the project (original cost of the project in present value terms). The profitability index is the ratio of the present value of a project's future cash flows to its initial cash outlay and is greater than one when a project's NPV is positive. ©20 15 Kaplan, Inc. Page 17 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting LOS 35.e An NPV profile plots a project's NPV as a function of the discount rate, and it intersects the horizontal axis (NPV == 0) at its IRR. If two NPV profiles intersect at some discount rate, that is the crossover rate, and different projects are preferred at discount rates higher and lower than the crossover rate. For projects with conventional cash flow patterns, the NPV and IRR methods produce the same accept/reject decision, but projects with unconventional cash flow patterns can produce multiple IRRs or no IRR. Mutually exclusive projects can be ranked based on their NPVs, but rankings based on other methods will not necessarily maximize the value of the firm. LOS 35.f The NPV method is a measure of the expected change in company value from undertaking a project. A firm's stock price may be affected to the extent that engaging in a project with that NPV was previously unanticipated by investors. Page 18 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting 1. Which of the following statements concerning the principles underlying the capital budgeting process is most accurate? A. Cash flows should be based on opportunity costs. B. Financing costs should be reflected in a project's incremental cash flows. C. The net income for a project is essential for making a correct capital budgeting decision. utsromleca 2. Which of the following statements about the payback period method is least accurate? The payback period: A. provides a rough measure of a project's liquidity. B. considers all cash flows throughout the entire life of a project. C. is the number of years it takes to recover the original cost of the • Investment. 3. Which of the following statements about NPV and IRR is least accurate? A. The IRR is the discount rate that equates the present value of the cash inflows with the present value of outflows. B. For mutually exclusive projects, if the NPV method and the IRR method give conflicting rankings, the analyst should use the IRRs to select the • proJect. C. The NPV method assumes that cash flows will be reinvested at the cost of capital, while IRR rankings implicitly assume that cash flows are reinvested at the IRR. 4. Which of the following statements is least accurate? The discounted payback period: A. frequently ignores terminal values. B. is generally shorter than the regular payback. C. is the time it takes for the present value of the project's cash inflows to equal the initial cost of the investment. 5. Which of the following statements about NPV and IRR is least accurate? A. The IRR can be positive even if the NPV is negative. B. When the IRR is equal to the cost of capital, the NPV will be zero. C. The NPV will be positive if the IRR is less than the cost of capital. ©20 15 Kaplan, Inc. Page 19 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting Use the following data to answer Questions 6 through 10. A company is considering the purchase of a copier that costs $5,000. Assume a required rate of return of 100/0and the following cash flow schedule: • • • Year 1: $3,000. Year 2: $2,000. Year 3: $2,000. 6. What is the project's payback period? A. 1.5 years. B. 2.0 years. C. 2.5 years. 7. The project's discounted payback period is closest to: A. 1.4 years. B. 2.0 years. C. 2.4 years. 8. What is the project's NPV? A. -$309. B. +$883. C. +$1,523. 9. The project's IRR is closest to: A. 100/0. B. 150/0. C. 20%. 10. What is the project's profitability index (PI)? A. 0.72. B. 1.18. C. 1.72. 11. An • • • • utsroleca analyst has gathered the following information about a project: Cost $10,000 Annual cash inflow $4,000 Life 4 years Cost of capital 120/0 Which of the following statements about the project is least accurate? A. The discounted payback period is 3.5 years. B. The IRR of the project is 21.9%; accept the project. C. The NPV of the project is +$2,149; accept the project. Page 20 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting Use the following data for Questions 12 and 13. An analyst has gathered the following data about two projects, each with a 120/0 required rate of return. ytrojecaZYP Initial cost Life Cash inflows 12. Project Y Project Z $15,000 $20,000 5 years 4 years $5,000/year $7,500/year If the projects are independent, the company should: A. accept Project Y and reject Project Z. B. reject Project Y and accept Project Z. c. accept both projects. c 13. If the projects are mutually exclusive, the company should: A. reject both projects. B. accept Project Y and reject Project Z. C. reject Project Y and accept Project Z. 14. The NPV profiles of two projects will intersect: A. at their internal rates of return. B. if they have different discount rates. C. at the discount rate that makes their net present values equal. 15. The post-audit is used to: A. improve cash flow forecasts and stimulate management to improve operations and bring results into line with forecasts. B. improve cash flow forecasts and eliminate potentially profitable but risky • proJects. C. stimulate management to improve operations, bring results into line with forecasts, and eliminate potentially profitable but risky projects. 16. Fullen Machinery is investing $400 million in new industrial equipment. The present value of the future after-tax cash flows resulting from the equipment is $700 million. Fullen currently has 200 million shares of common stock outstanding, with a current market price of $36 per share. Assuming that this project is new information and is independent of other expectations about the company, what is the theoretical effect of the new equipment on Fullen's stock price? The stock price will: A. decrease to $33.50. B. increase to $37.50. C. increase to $39.50. ©20 15 Kaplan, Inc. Page 21 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting 1. A Cash flows are based on opportunity costs. Financing costs are recognized in the project's required rate of return. Accounting net income, which includes non-cash expenses, is irrelevant; incremental cash flows are essential for making correct capital budgeting decisions. 2. B The payback period ignores cash flows that go beyond the payback period. 3. B NPV should always be used if NPV and IRR give conflicting decisions. 4. B The discounted payback is longer than the regular payback because cash flows are discounted to their present value. 5. C If IRR is less than the cost of capital, the result will be a negative NPV. 6. B Cash flow (CF) after year 2 the first two years. 7. C Year 1 discounted cash flow = 3,000 / 1.10 = 2,727; year 2 DCF = 2,000 / 1.102 = 1,653; year 3 DCF = 2,000 / 1.103 = 1,503. CF required after year 2 = -5,000 + 2,727 +1,653 = -$620,620/ year 3 DCF = 620 / 1,503 = 0.41, for a discounted payback of 2.4 years. = -5,000 + 3,000 + 2,000 = o. Cost of copier is paid back in Using a financial calculator: Year 1: I = 10%; FV = 3,000; N = 1; PMT = 0; CPT -+ PV = -2,727 Year 2: N = 2; FV = 2,000; CPT -+ PV = -1,653 Year 3: N = 3; CPT -+ PV = -1,503 5,000 - (2,727 + 1,653) = 620, 620 / 1,503 = 0.413, so discounted payback = 2.4. 2 + 0.4 8. B NPV = CFo + (discounted cash flows years 0 to 3 calculated in Question 7) + (2,727 + 1,653 + 1,503) = -5,000 + 5,833 = $883. 9. C From the information given, you know the NPV is positive, so the IRR must be greater than 10%. You only have two choices, 15% and 200/0. Pick one and solve the NPV; if it's not close to zero, you guessed wrong-pick the other one. Alternatively, you can solve directly for the IRR as CFo = -5,000, CF1 = 3,000, CF2 = 2,000, CF3 = 2,000. IRR = 20.64%. = -5,000 10. B PI = PV of future cash flows / CFo (discounted cash flows years 0 to 3 calculated in Question 7). PI = (2,727 + 1,653 + 1,503) /5,000 = 1.177. 11. A The discounted payback period of 3.15 is calculated as follows: CIb=-10,000; and PVCF4 393 year 4 DCF Page 22 = PVCI1 = 4,000 1.12 4,000 4 1.12 = 2,542. 393 2,542 = 0.15, = 3,571; PVCI1 = 4,000 2 1.12 = 3,189; PVCF.3 = 4,000 3 1.12 = 2,847; CF after year 3 =-10,000 + 3,571 + 3,189 + 2,847 =-393 for a discounted payback period of 3.15 years. ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #35 - Capital Budgeting 12. C Independent projects accept all with positive NPVs or IRRs greater than cost of capital. NPV computation is easy-treat cash flows as an annuity. Project Y: NB = 5; I = 12; PMT = 5,000; FV NPVA = 18,024 - 15,000 = $3,024 = 0; CPT -+ PV = -18,024 Project Z: N = 4; I = 12; PMT = 7,500; FV NPVB = 22,780 - 20,000 = $2,780 = 0; CPT -+ PV = -22,780 13. B Accept the project with the highest NPY. 14. C The crossover rate for the NPV profiles of two projects occurs at the discount rate that results in both projects having equal NPVs. 15. A A post-audit identifies what went right and what went wrong. It is used to improve forecasting and operations. 16. B The NPV of the new equipment is $700 million - $400 million = $300 million. The value of this project is added to Fullen's current market value. On a per-share basis, the addition is worth $300 million / 200 million shares, for a net addition to the share price of$I.50. $36.00 + $1.50 = $37.50. ©20 15 Kaplan, Inc. Page 23 The following is a review of the Corporate Finance principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #36.TSPOLIFCA COST OF CAPITAL Study Session 11XMEA EXAM Focus The firm must decide how to raise the capital to fund its business or finance its growth, dividing it among common equity, debt, and preferred stock. The mix that produces the minimum overall cost of capital will maximize the value of the firm (share price). From this topic review, you must understand weighted average cost of capital and its calculation and be ready to calculate the costs of common equity, preferred stock, and the after-tax cost of debt. Don't worry about choosing among the methods for calculating the cost of common equity; the information given in the question will make it clear which one to use. You must know all these methods and understand why the marginal cost of capital increases as greater amounts of capital are raised over a given period (usually taken to be a year). LOS 36.a: Calculate and interpret the weighted average cost of capital (WACC) of a company. LOS 36.b: Describe how taxes affect the cost of capital from different capital sources. utsrponmligecaVPCA CPA ® Program Curriculum, Volume 4, page 36 The capital budgeting process involves discounted cash flow analysis. To conduct such analysis, you must know the firm's proper discount rate. This topic review discusses how, as an analyst, you can determine the proper rate at which to discount the cash flows associated with a capital budgeting project. This discount rate is the firm's weighted average cost of capital (WACC) and is also referred to as the marginal cost of capital (MCC). Basic definitions. On the right (liability) side of a firm's balance sheet, we have debt, preferred stock, and common equity. These are normally referred to as the capital components of the firm. Any increase in a firm's total assets will have to be financed through an increase in at least one of these capital accounts. The cost of each of these components is called the component cost of capital. Throughout this review, we focus on the following capital components and their component costs: kd The rate at which the firm can issue new debt. This is the yield to maturity on existing debt. This is also called the before-tax component cost of debt. kd(l - t) The after-tax cost of debt. Here, t is the firm's marginal tax rate. The aftertax component cost of debt, kd(l - t), is used to calculate the WACC. Page 24 ©20 15 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital kps The cost of preferred stock. kee The cost of common equity. It is the required rate of return on common stock and is generally difficult to estimate. In many countries, the interest paid on corporate debt is tax deductible. Because we are interested in the after-tax cost of capital, we adjust the cost of debt, kd' for the firm's marginal tax rate, t. Because there is typically no tax deduction allowed for payments to common or preferred stockholders, there is no equivalent deduction to kps or kee. kd tspk How a company raises capital and how it budgets or invests it are considered independently. Most companies have separate departments for the two tasks. The financing department is responsible for keeping costs low and using a balance of funding sources: common equity, preferred stock, and debt. Generally, it is necessary to raise each type of capital in large sums. The large sums may temporarily overweight the most recently issued capital, but in the long run, the firm will adhere to target weights. Because of these and other financing considerations, each investment decision must be made assuming a WACC, which includes each of the different sources of capital and is based on the longrun target weights. A company creates value by producing a return on assets that is higher than the required rate of return on the capital needed to fund those assets. The WACC, as we have described it, is the cost of financing firm assets. We can view this cost as an opportunity cost. Consider how a company could reduce its costs if it found a way to produce its output using fewer assets, like less working capital. If we need less working capital, we can use the funds freed up to buy back our debt and equity securities in a mix that just matches our target capital structure. Our after-tax savings would be the WACC based on our target capital structure multiplied by the total value of the securities that are no longer outstanding. For these reasons, any time we are considering a project that requires expenditures, comparing the return on those expenditures to the WACC is the appropriate way to determine whether undertaking that project will increase the value of the firm. This is the essence of the capital budgeting decision. Because a firm's WACC reflects the average risk of the projects that make up the firm, it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than-average risk. The weights in the calculation of a firm's WACC are the proportions of each source of capital in a firm's capital structure. Calculating a Company's Weighted Average Cost of Capital The WACC is given by: where: w d = percentage of debt in the capital structure w s = percentage of preferred stock in the capital structure w~e = percentage of common stock in the capital structure d ©20 15 Kaplan, Inc. Page 25 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital Example: Computing WACC Suppose Dexter, Inc.'s target capital structure is as follows: wd = 0.45, wps = 0.05, and Wee = 0.50 Its before-tax cost of debt is 80/0,its cost of equity is 120/0,its cost of preferred stock is 8.40/0, and its marginal tax rate is 400/0. Calculate Dexter's WACC. Answer: Dexter's WACC will be: WACC = (0.45)(0.08)(0.6) + (0.05)(0.084) + (0.50)(0.12) = 0.0858 ::: 8.60/0 LOS 36.c: Describe the use of target capital structure in estimating WACC and how target capital structure weights may be determined. urpomligecaVPCA CPA ® Program Curriculum, Volume 4, page 38 The weights in the calculation ofWACC should be based on the firm's target capital structure; that is, the proportions (based on market values) of debt, preferred stock, and equity that the firm expects to achieve over time. In the absence of any explicit information about a firm's target capital structure from the firm itself, an analyst may simply use the firm's current capital structure (based on market values) as the best indication of its target capital structure. If there has been a noticeable trend in the firm's capital structure, the analyst may want to incorporate this trend into his estimate of the firm's target capital structure. For example, if a firm has been reducing its proportion of debt financing each year for two or three years, the analyst may wish to use a weight on debt that is lower than the firm's current weight on debt in constructing the firm's target capital structure. Alternatively, an analyst may wish to use the industry average capital structure as the target capital structure for a firm under analysis. Example: Determining target capital structure weights The market values of a firm's capital are as follows: • • • • Debt outstanding: Preferred stock outstanding: Common stock outstanding: Total capital: $8 million $2 million $10 million $20 million What is the firm's target capital structure based on its existing capital structure? Page 26 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital Answer: debt 400/0, w d = 0.40 d preferred stock 100/0, w ps = 0.10 common stock 500/0, wee = 0.50 For the industry average approach, we would simply use the arithmetic average of the current market weights (for each capital source) from a sample of industry firms. LOS 36.d: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget. urpomligecaVPFCA CFA ® Program Curriculum, Volume 4, page 40 A company increases its value and creates wealth for its shareholders by earning more on its investment in assets than is required by those who provide the capital for the firm. A firm's WACC may increase as larger amounts of capital are raised. Thus, its marginal cost of capital, the cost of raising additional capital, can increase as larger amounts are invested in new projects. This is illustrated by the upward-sloping marginal cost of capital curve in Figure 1. Given the expected returns (IRRs) on potential projects, we can order the expenditures on additional projects from highest to lowest IRR. This will allow us to construct a downward sloping investment opportunity schedule, such as that shown in Figure 1. Figure 1: The Optimal Capital Budget Project IRR Cost of Capital (%) Investment Opportunity Schedule Optimal Capital Budget Marginal Cost of Capital New Capital Raised/Invested ($) ©20 15 Kaplan, Inc. Page 27 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital The intersection of the investment opportunity schedule with the marginal cost of capital curve identifies the amount of the optimal capital budget. The intuition here is that the firm should undertake all those projects with IRRs greater than the cost of funds, the same criterion developed in the capital budgeting topic review. This will maximize the value created. At the same time, no projects with IRRs less than the marginal cost of the additional capital required to fund them should be undertaken, as they will erode the value created by the firm. LOS 36.e: Explain the marginal cost of capital's role in determining the net present value of a project. urpomligecaVPCA CPA ® Program Curriculum, Volume 4, page 41 One cautionary note regarding the simple logic behind Figure 1 is in order. All projects do not have the same risk. The WACC is the appropriate discount rate for projects that have approximately the same level of risk as the firm's existing projects. This is because the component costs of capital used to calculate the firm's WACC are based on the existing level of firm risk. To evaluate a project with greater than (the firm's) average risk, a discount rate greater than the firm's existing WACC should be used. Projects with below-average risk should be evaluated using a discount rate less than the firm's WACC. An additional issue to consider when using a firm's WACC (marginal cost of capital) to evaluate a specific project is that there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project. These complexities aside, we can still conclude that the NPVs of potential projects of firm-average risk should be calculated using the marginal cost of capital for the firm. Projects for which the present value of the after-tax cash inflows is greater than the present value of the after-tax cash outflows should be undertaken by the firm. LOS 36.f: Calculate and interpret the cost of debt capital using the yield-tomaturity approach and the debt-rating approach. CPA ® Program Curriculum, Volume 4, page 42 The after-tax cost of debt, kd(l - t), is used in computing the WACC. It is the interest rate at which firms can issue new debt (kd) net of the tax savings from the tax deductibility of interest, kd(t): after-tax cost of debt = interest rate - tax savings = kd - kd(t) = kd(l - t) after-tax cost of debt Page 28 = kd(l - t) ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital Example: Cost of debt Dexter, Inc., is planning to issue new debt at an interest rate of 80/0.Dexter has a 400/0 marginal federal-plus-state tax rate. What is Dexter's cost of debt capital? Answer: kd(1 - t) d = 80/0(1- 0.4) = 4.80/0 zyxwvutsrponmlkihgfedcbaVTPNMIFCA Professor'sNote: It is important that you realize that the cost of debt is the market interest rate (yTM) on new (marginal) debt, not the coupon rate on the firm's existing debt. CPA Institute may provide you with both rates, and you need to select the current market rate. If a market YTM is not available because the firm's debt is not publicly traded, the analyst may use the rating and maturity of the firm's existing debt to estimate the beforetax cost of debt. If, for example, the firm's debt carries a single-A rating and has an average maturity of 15 years, the analyst can use the yield curve for single-A rated debt to determine the current market rate for debt with a 15-year maturity. This approach is an example of matrix pricing or valuing a bond based on the yields of comparable bonds. If any characteristics of the firm's anticipated debt would affect the yield (e.g., covenants or seniority), the analyst should make the appropriate adjustment to his estimated before-tax cost of debt. For firms that primarily employ floating-rate debt, the analyst should estimate the longer-term cost of the firm's debt using the current yield curve (term structure) for debt of the appropriate rating category. LOS 36.g: Calculate preferred stock. and interpret the cost of noncallable, nonconvertible CFA® Program Curriculum, Volume 4, page 45 The cost of preferred stock (kps) is: where: D ps = preferred dividends P = market price of preferred ©20 15 Kaplan, Inc. Page 29 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital Example: Cost of preferred stock Suppose Dexter, Inc., has preferred stock that pays an $8 dividend per share and sells for $100 per share. What is Dexter's cost of preferred stock? Answer: kps = $8 I $100 PI = 0.08 = 80/0 Note that the equation kps= Dps I P is just a rearrangement of the preferred stock valuation model P = Dps I kps' where P is the market price. LOS 36.h: Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yield-plus risk-premium approach. utrponmlkigecaVSRPECA CPA ® Program Curriculum, Volume 4, page 46 The opportunity cost of equity capital (kce) is the required rate of return on the firm's common stock. The rationale here is that the firm could avoid part of the cost of common stock outstanding by using retained earnings to buy back shares of its own stock. The cost of (i.e., the required return on) common equity can be estimated using one of the following three approaches: 1. The capital asset pricing model approach. Step 1: Estimate the risk-free rate, RFR. Yields on default risk-free debt such as u.s. Treasury notes are usually used. The most appropriate maturity to choose is one that is close to the useful life of the project. Step 2: Estimate the stock's beta, {3. This is the stock's risk measure. Step 3: Estimate the expected rate of return on the market, E(Rrnkt). Step 4: Use the capital asset pricing model (CAPM) equation to estimate the required rate of return: Example: Using CAPM to estimate kce Suppose RFR = 60/0, Rmkt = 110/0, and Dexter has a beta of 1.1. Estimate Dexter's cost of equity. Answer: The required rate of return for Dexter's stock is: kce = Page 30 60/0 + 1.1(11 % - 60/0) = 11.50/0 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capitalywvutsrponmlihgfed Professor'sNote: If you are unfamiliar with the capital assetpricing model, you can find more detail and the basic elements of its derivation in the Study Session on portfolio management. gfI 2. The dividend discount model approach. If dividends are expected to grow at a constant rate, g, then the current value of the stock is given by the dividend growth model: where: D 1 == next year's dividend kee == required rate of return on common equity g == firm's expected constant growth rate okgD Rearranging the terms, you can solve for kee: D k ce == p. 1 + g o In order to use kce can be done by: • • == Dl + g, you have to estimate the expected growth rate, g. This Po Using the growth rate as projected by security analysts. Using the following equation to estimate a firm's sustainable growth rate: g == (retention rate)(return on equity) == (1 - payout rate) (ROE) The difficulty with this model is estimating the firm's future growth rate. Example: Estimating kce using the dividend discount model Suppose Dexter's stock sells for $21, next year's dividend is expected to be $1, Dexter's expected ROE is 120/0, and Dexter is expected to payout 400/0 of its earnings. What is Dexter's cost of equity? Answer: g == (ROE)(retention g == (0.12)(1 - 0.4) kce == (1 /21) + 0.072 rate) == 0.072 == == 7.20/0 0.12 or 120/0 ©20 15 Kaplan, Inc. Page 31 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital 3. Bond yield plus risk premium approach. Analysts often use an ad hoc approach to estimate the required rate of return. They add a risk premium (three to five percentage points) to the market yield on the firm's long-term debt. kce = bond yield + risk premium k Example: Estimating kce with bond yields plus a risk premium Dexter's interest rate on long-term debt is 80/0. Suppose the risk premium is estimated to be 50/0. Estimate Dexter's cost of equity. Answer: Dexter's estimated cost of equity is: kce = 80/0 + 50/0 = 130/0 Note that the three models gave us three different estimates of kce' The CAPM estimate was 11.50/0, the dividend discount model estimate was 120/0, and the bond yield plus risk premium estimate was 130/0. Analysts must use their judgment to decide which is most appropriate. LOS 36.i: Calculate and interpret the beta and cost of capital for a project. yurpomligecaVPCA CPA ® Program Curriculum, Volume 4, page 52 A project's beta is a measure of its systematic or market risk. Just as we can use a firm's beta to estimate its required return on equity, we can use a project's beta to adjust for differences between a specific project's risk and the average risk of a firm's projects. Because a specific project is not represented by a publicly traded security, we typically cannot estimate a project's beta directly. One process that can be used is based on the equity beta of a publicly traded firm that is engaged in a business similar to, and with risk similar to, the project under consideration. This is referred to as the pure-play method because we begin with the beta of a company or group of companies that are purely engaged in a business similar to that of the project and are therefore comparable to the project. Thus, using the beta of a conglomerate that is engaged in the same business as the project would be inappropriate because its beta depends on its many different lines of business. The beta of a firm is a function not only of the business risks of its projects (lines of business) but also of its financial structure. For a given set of projects, the greater a firm's reliance on debt financing, the greater its equity beta. For this reason, we must adjust the pure-play beta from a comparable company (or group of companies) for the company's leverage (unlever it) and then adjust it (re-Iever it) based on the financial structure of the company evaluating the project. We can then use this equity beta to calculate the cost of equity to be used in evaluating the project. Page 32 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital To get the asset beta for a publicly traded firm, we use the following formula: yutsrponmljifecbaIED 1 ~ASSETE = ~EQUITY 1+ (1- t) 0 E where: DIE == comparable company's debt-to-equity ratio and t is its marginal tax rate To get the equity beta for the project, we use the subject firm's tax rate and debt-to-equity • ratio: ~PROJECT = ~ASSET 1+ o (1- t)E The following example illustrates this technique. Example: Cost of capital for a project Acme, Inc., is considering a project in the food distribution business. It has a DIE ratio of 2, a marginal tax rate of 400/0, and its debt currently has a yield of 140/0. Balfor, a publicly traded firm that operates only in the food distribution business, has a DIE ratio of 1.5, a marginal tax rate of 300/0, and an equity beta of 0.9. The risk-free rate is 50/0, and the expected return on the market portfolio is 120/0. Calculate Balfor's asset beta, the project's equity beta, and the appropriate WACC to use in evaluating the project. Answer: Balfor's asset beta: ~ - 09 ~ ASSET- . 1 1+ (1- 0.3) (1.5) = 0.439 Equity beta for the project: ~PROJECT == 0.439[1 + (1 - 0.4)(2)] Project cost of equity == == 0.966 50/0 + 0.966(120/0 - 50/0) == 11.7620/0 To get the weights of debt and equity, use the DIE ratio and give equity a value of 1. Here, DIE == 2, so ifE == 1,0 == 2. The weight for debt, 0/(0 + E), is 2/(2 + 1) == 2/3, and the weight for equity, E/(O + E), is 1/(2 + 1) == 1/3. The appropriate WACC for the project is therefore: OE 1 2 3 3 -(11.7620/0)+-(140/0)(1-0.4) = 9.520/0 ©20 15 Kaplan, Inc. Page 33 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital While the method is theoretically correct, there are several challenging issues involved in estimating the beta of the comparable (or any) company's equity: • • • • Beta is estimated using historical returns data. The estimate is sensitive to the length of time used and the frequency (daily, weekly, etc.) of the data. The estimate is affected by which index is chosen to represent the market return. Betas are believed to revert toward lover time, and the estimate may need to be adjusted for this tendency. Estimates of beta for small-capitalization firms may need to be adjusted upward to reflect risk inherent in small firms that is not captured by the usual estimation methods. LOS 36.j: Describe uses of country risk premiums in estimating the cost of • equIty. X urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 59 Using the CAPM to estimate the cost of equity is problematic in developing countries because beta does not adequately capture country risk. To reflect the increased risk associated with investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM. The general risk of the developing country is reflected in its sovereign yield spread. This is the difference in yields between the developing country's government bonds (denominated in the developed market's currency) and Treasury bonds of a similar maturity. To estimate an equity risk premium for the country, adjust the sovereign yield spread by the ratio of volatility between the country's equity market and its government bond market (for bonds denominated in the developed market's currency). A more volatile equity market increases the country risk premium, other things equal. The revised CAPM equation is stated as: where: CRP = country risk premium The country risk premium can be calculated as: CRP = sovereign yield spread annualized standard deviation of equity index of developing country X -----------=------=------=------- annualized standard deviation of sovereign bond market in terms of the developed market currency where: sovereign yield spread = difference between the yields of government bonds in the developing country and Treasury bonds of similar maturities Page 34 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital Example: Country risk premium Robert Rodriguez, an analyst with Omni Corporation, is estimating the cost of equity for a project Omni is starting in Venezuela. Rodriguez has compiled the following information for his analysis: • • • • Project beta = 1.25. Expected market return = 10.40/0. Risk-free rate = 4.20/0. Country risk premium = 5.530/0. Calculate the cost of equity for Omni's Venezuelan project. Answer: kce = RF +~[E(RMKT)- RF +CRP] = 0.042 + 1.25[0.104 - 0.042 + 0.0553] = 0.042 + 1.25[0.1173] = 0.1886, or 18.860/0 LOS 36.k: Describe the marginal cost of capital schedule, explain why it may be upward-sloping with respect to additional capital, and calculate and interpret its break-points. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 61 The marginal cost of capital (MCC) is the cost of the last new dollar of capital a firm raises. As a firm raises more and more capital, the costs of different sources of financing will increase. For example, as a firm raises additional debt, the cost of debt will rise to account for the additional financial risk. This will occur, for example, if bond covenants in the firm's existing senior debt agreement prohibit the firm from issuing additional debt with the same seniority as the existing debt. Therefore, the company will have to issue more expensive subordinated bonds at a higher cost of debt, which increases the marginal cost of capital. Also, issuing new equity is more expensive than using retained earnings due to flotation costs (which are discussed in more detail in the next LOS). The bottom line is that raising additional capital results in an increase in the WACC. The marginal cost of capital schedule shows the WACC for different amounts of financing. Typically, the MCC is shown as a graph. Because different sources of financing become more expensive as the firm raises more capital, the MCC schedule typically has an upward slope. Break points occur any time the cost of one of the components of the company's WACC changes. A break point is calculated as: break point amount of capital at which the component's cost of capital changes = -----=-------------=-----------=------=--- weight of the component in the capital structure ©20 15 Kaplan, Inc. Page 35 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital Example: Calculating break points The Omni Corporation has a target capital structure of 600/0 equity and 400/0 debt. The schedule of financing costs for the Omni Corporation is shown in the figure below. Schedule of Capital Costs for Omni yxwutsrqponmlifebaWTNEDCA Amount of New Debt Amount of New After- Tax Cost of Debtm Cost of Equity ~m~~ ~~~m~~I I~--------------------------------------------------------------~ $0 to $99 4.20/0 $0 to $199 6.50/0 $100 to $199 4.60/0 $200 to $399 8.00/0 $200 to $299 5.00/0 $400 to $599 9.50/0 Calculate the break points for Omni Corporation and graph the marginal cost of capital schedule. Answer: Omni will have a break point each time a component cost of capital changes, for a total of four break points. break pointdebt > $100mm = $100 million = $250 m nuIon 0.4 break pointdebt > $200mm = $200 million = $500 m nuIon 0.4 . $200 million $ ·11· b reak pOlntequity>$200mm = = 333 rru Ion 0.6 . $400 million $66 milli b reak p01ntequity> $400mm = = 7 Ion 0.6 The following figure shows Omni Corporation's WACC for the different break points. WACC for Alternative Levels of Financing Page 36 Capital (in millions) Equity (60%) Cost of Equity Debt (40%) Cost of Debt WACC $50 $30 6.5% $20 4.20/0 5.58% $250 $150 6.5% $100 4.60/0 5.74% $333 $200 8.0% $133 4.60/0 6.64% $500 $300 8.0% $200 5.00/0 6.80% $667 $400 9.5% $267 5.00/0 7.70% ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital The following figure is a graph of the marginal cost of capital schedule given in the previous figure. Notice the upward slope of the line due to the increased financing costs as more financing is needed. Marginal Cost of Capital Schedule for Omni Corporation WACC (0/0) 7.700/0 7.5 6.800/0 7.0 6.640/0 , 6.5 6.0 r 5.74% , ,, , , , , ,, , 250 333 5.58% , , , , , 5.5 , , , , , , , ,, , ,, , ,, 500 667 Capital raised LOS 36.1: Explain and demonstrate the correct treatment of flotation costs. ywutsrqponmlihgfedcaVPNMHFCA CFA ® Program Curriculum, Volume 4, page 64 Flotation costs are the fees charged by investment bankers when a company raises external equity capital. Flotation costs can be substantial and often amount to between 20/0and 7% of the total amount of equity capital raised, depending on the type of offering. Incorrect Treatment of Flotation Costs Because the LOS asks for the "correct treatment of flotation costs," that implies that there is an incorrect treatment. Many financial textbooks incorporate flotation costs directly into the cost of capital by increasing the cost of external equity. For example, if a company has a dividend of $1.50 per share, a current price of $30 per share, and an expected growth rate of 60/0, the cost of equity without flotation costs would be: re = $1.50(1 + 0.06) $30 + 0.06 = 0.1130, or 11.300/0 Professor's Note: Here we're using the constant growth model, rather than the CAPM, to estimate the cost of equity. ©20 15 Kaplan, Inc. Page 37 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital If we incorporate flotation costs of 4.50/0 directly into the cost of equity computation, the cost of equity increases: re = $1.50(1 + 0.06) $30 (1-0.045 ) +0.06=0.1155,or11.550/0 rnA Correct Treatment of Flotation Costs In the incorrect treatment we have just seen, flotation costs effectively increase the WACC by a fixed percentage and will be a factor for the duration of the project because future project cash flows are discounted at this higher WACC to determine project NPV. The problem with this approach is that flotation costs are not an ongoing expense for the firm. Flotation costs are a cash outflow that occurs at the initiation of a project and affect the project NPV by increasing the initial cash outflow. Therefore, the correct way to account for flotation costs is to adjust the initial project cost. An analyst should calculate the dollar amount of the flotation cost attributable to the project and increase the initial cash outflow for the project by this amount. ywutsrponljihfedca Example: Correctly accounting for Hotation costs Omni Corporation is considering a project that requires a $400,000 cash outlay and is expected to produce cash flows of $150,000 per year for the next four years. Omni's tax rate is 350/0, and the before-tax cost of debt is 6.50/0.The current share price for Omni's stock is $36 per share, and the expected dividend next year is $2 per share. Omni's expected growth rate is 50/0.Assume that Omni finances the project with 500/0debt and 500/0equity capital and that flotation costs for equity are 4.50/0. The appropriate discount rate for the project is the WACC. Calculate the NPV of the project using the correct treatment of flotation costs and discuss how the result of this method differs from the result obtained from the incorrect treatment of flotation costs. Page 38 ©2015 Kaplan, Inc. Cross-Reference Study Session 11 to CFA Institute Assigned Reading #36 - Cost of Capital Answer: after-tax cost of debt = 6.50/0 (1- 0.35) = 4.230/0 cost of equity = $2 +0.05 = 0.1055, or 10.550/0 $36 WACC = 0.50(0.0423)+0.50(0.1055) = 7.39% Because the project is financed with 500/0 equity, the amount of equity capital raised is 0.50 x $400,000 = $200,000. Flotation costs are 4.50/0, which equates to a dollar cost of $200,000 x 0.045 = $9,000. NPV = -$400,000 -$9,000 + $150,000 + $150,000 + $150,000 + $150,000 1.0739 (1.0739)2 (1.0739)3 (1.0739)4 = $94,640 For comparison, if we would have adjusted the cost of equity for flotation costs, the cost of equity would have increased to 10.820/0 = $2.00 + 0.05 , which $36(1- 0.045) would have increased the WACC to 7.530/0. Using this method, the NPV of the project would have been: NPV = -$400,000 + $150,000 + $150,000 + $150,000 + $150,000 = $102,061 1.0753 (1.0753)2 (1.0753)3 (1.0753)4 The two methods result in significantly different estimates for the project NPV. Adjusting the initial outflow for the dollar amount of the flotation costs is the correct approach because it provides the most accurate assessment of the project's value once all costs are considered. Note that flotation costs may be tax-deductible for some firms. In that case, the initial cash flow of the project should be adjusted by the after-tax flotation cost. In this example, Omni would have an after-tax flotation cost of $9,000(1 - 0.35) = $5,850 and the project NPV would be $97,790. ©20 15 Kaplan, Inc. Page 39 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital LOS 36.a The weighted average cost of capital, or WACC, is calculated using weights based on the market values of each component of a firm's capital structure and is the correct discount rate to use to discount the cash flows of projects with risk equal to the average risk of a firm's projects. LOS 36.h Interest expense on a firm's debt is tax deductible, so the pre-tax cost of debt must be reduced by the firm's marginal tax rate to get an after-tax cost of debt capital: after-tax cost of debt » kd (1 - firm's marginal tax rate) The pre-tax and after-tax capital costs are equal for both preferred stock and common equity because dividends paid by the firm are not tax deductible. LOS 36.c WACC should be calculated based on a firm's target capital structure weights. If information on a firm's target capital structure is not available, an analyst can use the firm's current capital structure, based on market values, or the average capital structure in the firm's industry as estimates of the target capital structure. LOS 36.d A firm's marginal cost of capital (WACC at each level of capital investment) increases as it needs to raise larger amounts of capital. This is shown by an upward-sloping marginal cost of capital curve. An investment opportunity schedule shows the IRRs of (in decreasing order), and the initial investment amounts for, a firm's potential projects. The intersection of a firm's investment opportunity schedule with its marginal cost of capital curve indicates the optimal amount of capital expenditure, the amount of investment required to undertake all positive NPV projects. LOS 36.e The marginal cost of capital (the WACC for additional units of capital) should be used as the discount rate when calculating project NPVs for capital budgeting decisions. Adjustments to the cost of capital are necessary when a project differs in risk from the average risk of a firm's existing projects. The discount rate should be adjusted upward for higher-risk projects and downward for lower-risk projects. Page 40 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital LOS 36.f The before-tax cost of fixed-rate debt capital, kd' is the rate at which the firm can issue new debt. • The yield-to-maturity approach assumes the before-tax cost of debt capital is the YTM on the firm's existing publicly traded debt. • If a market YTM is not available, the analyst can use the debt rating approach, estimating the before-tax cost of debt capital based on market yields for debt with the same rating and average maturity as the firm's existing debt. LOS 36.g The cost (and yield) of noncallable, nonconvertible preferred stock is simply the annual dividend divided by the market price of preferred shares. LOS 36.h The cost of equity capital, kee' is the required rate of return on the firm's common stock. There are three approaches to estimating kee: • CAPM approach: kee;:;RFR + ~ [E(Rmkt) - RFR]. • Dividend discount model approach: kee ;:;(D1/PO) + g. • Bond yield plus risk premium approach: add a risk premium of30/0 to 50/0 to the market yield on the firm's long-term debt. tlOED LOS 36.i When a project's risk differs from that of the firm's average project, we can use the beta of a company or group of companies that are exclusively in the same business as the project to calculate the project's required return. This pure-play method involves the following steps: yutrpomlheda 1. Estimate the beta for a comparable company or companies. 2. Unlever the beta to get the asset beta using the marginal tax rate and debt-to-equity ratio for the comparable company: 1 ~ASSET = ~EQUITY 3. D 1+ (l-t)E Re-lever the beta using the marginal tax rate and debt-to-equity ratio for the firm considering the project: ~PROJECT = ~ASSET 1+ D (l-t)E 4. Use the CAPM to estimate the required return on equity to use when evaluating the • proJect. 5. Calculate the WACC for the firm using the project's required return on equity. ©20 15 Kaplan, Inc. Page 41 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital LOS 36.j A country risk premium should be added to the market risk premium in the Capital Asset Pricing Model to reflect the added risk associated with investing in a developing market. LOS 36.k The marginal cost of capital schedule shows the WACC for successively greater amounts of new capital investment for a period, such as the coming year. The MCC schedule is typically upward-sloping because raising greater amounts of capital increases the cost of equity and debt financing. Break points (increases) in the marginal cost of capital schedule occur at amounts of total capital raised equal to the amount of each source of capital at which the component cost of capital increases, divided by the target weight for that source of capital. LOS 36.1 The correct method to account for flotation costs of raising new equity capital is to increase a project's initial cash outflow by the flotation cost attributable to the project when calculating the project's NPV. Page 42 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital 1. A company has $5 million in debt outstanding with a coupon rate of 120/0. Currently, the yield to maturity (YTM) on these bonds is 140/0.If the firm's tax rate is 400/0,what is the company's after-tax cost of debt? A. 5.60/0. B. 8.40/0. C. 14.00/0. 2. The cost of preferred stock is equal to: A. the preferred stock dividend divided by its par value. B. [(1 - tax rate) times the preferred stock dividend] divided by price. C. the preferred stock dividend divided by its market price. 3. A company's $100,80/0 preferred is currently selling for $85. What is the company's cost of preferred equity? A. 8.00/0. B. 9.40/0. C. 10.80/0. 4. The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of equity if the long-term growth in dividends is projected to be 80/0? A. 15%. B. 160/0. C. 18%. 5. nA An analyst gathered the Capital structure 300/0debt 20% preferred stock 500/0common stock following data about a company: Required rate of return 100/0for debt 11 % for preferred stock 180/0for common stock Assuming a 400/0tax rate, what after-tax rate of return must the company earn on its investments? A. 13.00/0. B. 14.2%. C. 18.0%. 6. A company is planning a $50 million expansion. The expansion is to be financed by selling $20 million in new debt and $30 million in new common stock. The before-tax required return on debt is 9% and 140/0for equity. If the company is in the 400/0 tax bracket, the company's marginal cost of capital is closest to: A. 7.20/0. B. 10.60/0. C. 12.00/0. tsolec ©20 15 Kaplan, Inc. Page 43 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital Use the following data to answer Questions 7 through 10. • • • • • • A company has a target capital structure of400/0 debt and 600/0 equity. The company's bonds with face value of$1,000 pay a 100/0 coupon (semiannual), mature in 20 years, and sell for $849.54 with a yield to maturity of 120/0. The company stock beta is 1.2. Risk-free rate is100/0, and market risk premium is 50/0. The company is a constant-growth firm that just paid a dividend of $2, sells for $27 per share, and has a growth rate of 80/0. The company's marginal tax rate is400/0. 7. The company's after-tax cost of debt is: A. 7.20/0. B. 8.00/0. C. 9.10/0. 8. The company's cost of equity using the capital asset pricing model (CAPM) approach is: A. 16.00/0. B. 16.60/0. C. 16.90/0. 9. The company's cost of equity using the dividend discount model is: A. 15.40/0. B. 16.00/0. C. 16.60/0. 10. The company's weighted average cost of capital (using the cost of equity from CAPM) is closest to: A. 12.50/0. B. 13.00/0. C. 13.50/0. tsolec 11. Page 44 What happens to a company's weighted average cost of capital (WACC) if the firm's corporate tax rate increases and if the Federal Reserve causes an increase in the risk-free rate, respectively? (Consider the events independently and assume a beta of less than one.) Tax rate increase Increase in risk-free rate A. Decrease WACC Increase WACC B. Decrease WACC Decrease WACC C. Increase WACC Increase WACC ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital 12. Given the following information on a company's capital structure, what is the company's weighted average cost of capital? The marginal tax rate is 400/0. Percent of Before-tax Type of capital capital structure component cost Bonds 400/0 7.50/0 5% Preferred stock 110/0 Common stock 150/0 550/0 A. 10.00/0. B. 10.60/0. C. 11.80/0. 13. Derek Ramsey is an analyst with Bullseye Corporation, a major U.S.-based discount retailer. Bullseye is considering opening new stores in Brazil and wants to estimate its cost of equity capital for this investment. Ramsey has found that: • The appropriate beta to use for the project is1.3. • The market risk premium is60/0. • The risk-free interest rate is4.50/0. • The country risk premium for Brazil is3.1 %. Which of the following is closest to the cost of equity that Ramsey should use in his analysis? A. 10.50/0. B. 15.6%. C. 16.30/0. yxwutsrqonmlifecbaTNEDCA 14. Manigault Industries currently has assets on its balance sheet of $200 million that are financed with 700/0 equity and 300/0 debt. The executive management team at Manigault is considering a major expansion that would require raising additional capital. Rosannna Stallworth, the CFO of Manigault, has put together the following schedule for the costs of debt and equity: Amount of New Debt {in millions} After-Tax Cost of Debt Amount of New Equity {in millions} Cost of Equity $0 to $49 4.0% $0 to $99 7.00/0 $50 to $99 4.2% $100 to $199 8.00/0 $100 to $149 4.5% $200 to $299 9.00/0 ©20 15 Kaplan, Inc. Page 45 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital In a presentation to Manigault's Board of Directors, Stallworth makes the following statements: ytsonmlkiecaS Statement 1: If we maintain our target capital structure of 700/0 equity and 300/0 debt, the break point at which our cost of equity will increase to 8.00/0 is $185 million in new capital. Statement 2: If we want to finance total assets of $450 million, our marginal cost of capital will increase to 7.560/0. Are Stallworth's Statements 1 and 2 most likely correct or incorrect? Statement 1 Statement 2 A. Correct Correct B. Incorrect Correct C. Incorrect Incorrect Page 46 15. Black Pearl Yachts is considering a project that requires a $180,000 cash outlay and is expected to produce cash flows of $50,000 per year for the next five years. Black Pearl's tax rate is 250/0, and the before-tax cost of debt is 80/0.The current share price for Black Pearl's stock is $56 and the expected dividend next year is $2.80 per share. Black Pearl's expected growth rate is 50/0. Assume that Black Pearl finances the project with 600/0 equity and 400/0 debt, and the flotation cost for equity is 4.00/0. The appropriate discount rate is the weighted average cost of capital (WACC). Which of the following choices is closest to the dollar amount of the flotation costs and the NPV for the project, assuming that flotation costs are accounted for properly? Dollar amount of flotation costs NPV of project A. $4,320 $17,548 B. $4,320 $13,228 C. $7,200 $17,548 16. Jay Company has a debt-to-equity ratio of 2.0. Jay is evaluating the cost of equity for a project in the same line of business as Cass Company and will use the pure-play method with Cass as the comparable firm. Cass has a beta of 1.2 and a debt-to-equity ratio of 1.6. The project beta most likely: A. will be less than Jay Company's beta. B. will be greater than Jay Company's beta. C. could be greater than or less than Jay Company's beta. ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital 1. B kxtpnmkjidaTRPMKFEDCB (1 - t) = (0.14)(1 - 0.4) d 2. C Cost of preferred stock = kps = D ps / P 3. B kps = Dps / Pps' Dps= $100 4. C Using the dividend yield plus growth rate approach: kee = (D. / Po) + g = (2.50 / 25.00) + 80/0 = 18%. 5. A WACC = (wd)(kd)(1 - t) + (wps)(kps) + (wee)(kee) = (0.3)(0.1)(1 - 0.4) + (0.2)(0.11) + (0.5)(0.18) = 130/0 6. B wd = 20 / (20 + 30) = 0.4, wee = 30/ (20 + 30) = 0.6 = x 8.40/0 8% = $8, kps= 8 / 85 = 9.4% WACC = (wd)(kd)(1 - t) +woke(we~(ke~ = 7.20/0 (0.4)(9)(1 - 0.4) + (0.6)(14) = 10.560/0 = MCC 7. A kd(1 - t) 8. A Using the CAPM formula, kee = RFR 9. B D. = Do (1 + g) = 2(1.08) = 2.16; kce = (D, / Po) + g = (2.16/27) = 12(1 - 0.4) = + ~[E(Rmkt) - RFR] = 10 + 1.2(5) = 160/0. + 0.08 = 16% 10. A WACC = (wd)(kd)(1 - t) + (we~(ke~ = (0.4)(7.2) + (0.6)(16) = 12.48% 11. A An increase in the corporate tax rate will reduce the after-tax cost of debt, causing the WACC to fall. More specifically, because the after-tax cost of debt = (kd)(1 - t), the term (1 - t) decreases, decreasing the after-tax cost of debt. If the risk-free rate were to increase, the costs of debt and equity would both increase, thus causing the firm's cost of capital to increase. 12. B WACC = (wd)(kd)(1 - t) + (wps)(kps) + (wee)(kee) = (0.4)(7.5)(1 - 0.4) + (0.05)(11) + (0.55)(15) = 10.60/0 13. C ke = Rp + ~[E(RMKT) - Rp + CRPj = 0.045 + 1.3[0.06 + 0.031] = 0.163, or 16.3% Note that the "market risk premium" refers to the quantity [E(RMKT) 14. C - Rp]. Statement 1 is incorrect. The break point at which the cost of equity changes to 8.00/0 is: ak pOInt ooi = amount of capital at which the component's cost of capital changes re --=--='=--__ b weight of the component in the WACC -=o_ = $100 million = $142.86 million 0.70 Statement 2 is also incorrect. If Manigault wants to finance $450 million of total assets, that means that the firm will need to raise $450 - $200 = $250 million in additional capital. Using the target capital structure of 70% equity, 30% debt, the firm will need to raise 0.70 x $250 = $175 million in new equity and 0.30 x $250 = $75 in new debt. Looking at the capital schedule, the cost associated with $75 million in new debt is ©20 15 Kaplan, Inc. Page 47 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #36 - Cost of Capital 4.20/0, and the cost associated with $175 million in new equity is 8.0%. The marginal cost of capital at that point will be (0.3xf x 4.2%) + (0.7 x 8.0%) = 6.860/0. 15. B Because the project is financed with 60% equity, the amount of equity capital raised is 0.60 x $180,000 = $108,000. Flotation costs are 4.0%, which equates to a dollar cost of $108,000 x 0.04 After-tax cost of debt . Cost 0f equity WACC = = = 8.00/0 (1 - 0.25) $2.80 $56.00 +0.05 0.60(0.10) + 0.40(0.06) = = = $4,320. 6.0% 0.10, or 10.0% = 8.40/0 NPV= -$180,000-$4,320+ 16. C Page 48 $50,000 + $50,000 + $50,000 + $50,000 + $50,000 = $13,228 1.084 (1.084)2 (1.084)3 (1.084)4 (1.084)5 The project beta calculated using the pure-play method is not necessarily related in a predictable way to the beta of the firm that is performing the project. ©20 15 Kaplan, Inc. The following is a review of the Corporate Finance principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #37.VUSROMLGFEA MEASURES OF LEVERAGE Study Session 11XMEA EXAM Focus Here we define and calculate various measures of leverage and the firm characteristics that affect the levels of operating and financial leverage. Operating leverage magnifies the effect of changes in sales on operating earnings. Financial leverage magnifies the effect of changes in operating earnings on net income (earnings per share). The breakeven quantity of sales is that quantity of sales for which total revenue just covers total costs. The operating breakeven quantity of sales is the quantity of sales for which total revenue just covers total operating costs. Be sure you understand how a firm's decisions regarding its operating structure and scale and its decisions regarding the use of debt and equity financing (its capital structure) affect its breakeven levels of sales and the uncertainty regarding its operating earnings and net income. LOS 37.a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk. vutsrponmlihgfecaVTPNJCBA CPA ® Program Curriculum, Volume 4, page 82 Leverage, in the sense we use it here, refers to the amount of fixed costs a firm has. These fixed costs may be fixed operating expenses, such as building or equipment leases, or fixed financing costs, such as interest payments on debt. Greater leverage leads to greater variability of the firm's after-tax operating earnings and net income. A given change in sales will lead to a greater change in operating earnings when the firm employs operating leverage; a given change in operating earnings will lead to a greater change in net income when the firm employs financial leverage. Professor's Note: The British refer to leverage as "gearing. J> Business risk refers to the risk associated with a firm's operating income and is the result of uncertainty about a firm's revenues and the expenditures necessary to produce those revenues. Business risk is the combination of sales risk and operating risk. • • Sales risk is the uncertainty Operating risk refers to the by fixed operating costs. The the greater a firm's operating about the firm's sales. additional uncertainty about operating earnings caused greater the proportion of fixed costs to variable costs, risk. Financial risk refers to the additional risk that the firm's common stockholders must bear when a firm uses fixed cost (debt) financing. When a company finances its operations with debt, it takes on fixed expenses in the form of interest payments. The greater the proportion of debt in a firm's capital structure, the greater the firm's financial risk. ©20 15 Kaplan, Inc. Page 49 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #37 - Measures of Leverage LOS 37.b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage. urpomligecaVPCA CPA ® Program Curriculum, Volume 4, page 86 The degree of operating leverage (DOL) is defined as the percentage change in operating income (EBIT) that results from a given percentage change in sales: ~EBIT percentage change in EBIT DO L = -=-------------=---=------percentage change in sales EBIT Q ~Q VQPF Q To calculate a firm's DOL for a particular level of unit sales, Q, DOL is: Q DOL = Q(P- V) Q(P-V)-F where: Q = quantity of units sold P = price per unit V = variable cost per unit F = fixed costs Multiplying, we have: DOL = S-TVC S-TVC-F where: S = sales TVC = total variable costs F = fixed costs Note that in this form, the denominator is operating earnings (EBIT). Page 50 ©2015 Kaplan, Inc. Study Session 11 to CFA Institute Assigned Reading #37 - Measures of Leverage Cross-Reference Example: Degree of operating leverage Consider the costs for the projects presented in the following table. Assuming that 100,000 units are produced for each firm, calculate the DOL for Atom Company and Beta Company. Operating Costs for Atom Company and Beta Company Atom Company Beta Company Price $4.00 $4.00 Variable costs $3.00 $2.00 Fixed costs $40,000 $120,000 Revenue $400,000 $400,000 ytponmeaCBA Answer: For Atom Company: Q(P-V) DOL (Atom) = [( QF Q P-V 100,000( 4 - 3) )] -F [100,000 (4 - 3) - 40,000] DOL(Atom) = 100,000 = 1.67 60,000 For Beta Company: Q(P- DOL (Beta) = [ Q(P- V) V)-F] - 100,000(4-2) [100,000(4-2)-120,000] DOL (Beta) = 200,000 = 2.50 80,000 The results indicate that if Beta Company has a 100/0increase in sales, its EBIT will increase by 2.50 x 100/0= 250/0,while for Atom Company, the increase in EBIT will be 1.67 x 100/0= 16.70/0. It is important to note that the degree of operating leverage for a company depends on the level of sales. For example, if Atom Company sells 300,000 units, the DOL is decreased: Q(P-V) DOL (Atom) = [( Q P-V 300,000 (4 - 3) )] -F .,------_____:_-___:__---o- [300,000 (4 - 3) - 40,000] = 300,000 = 1.15 260,000 DOL is highest at low levels of sales and declines at higher levels of sales. ©20 15 Kaplan, Inc. Page 51 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #37 - Measures of Leverage The degree of financial leverage (D FL) is interpreted as the ratio of the percentage change in net income (or EPS) to the percentage change in EBIT: DFL= percentage change in EPS percentage change in EBIT For a particular level of operating earnings, DFL is calculated as: DFL = __ E_B_I_T __ EBIT - interest zyxwvutsrqponmlkihgfedcbaVTSPONLFED Professor'sNote: The terms 'earnings per share" (EPS) and "net income" are used interchangeably in this topic review. Example: Degree of financial leverage From the previous example, Atom Company's operating income for selling 100,000 units is $60,000. Assume that Atom Company has annual interest expense of $18,000. If Atom's EBIT increases by 100/0, by how much will its earnings per share increase? Answer: DFL= $60,000 = 1.43 $60,000 - $18,000 EBIT EBIT-I %~EPS = DFLx%~EBIT = 1.43x100/o = 14.30/0 Hence, earnings per share will increase by 14.30/0. Professor'sNote: Look back at the formulas for DOL and DFL and convince yourself that if there are no fixed costs, DOL is equal to one, and that if there are no interest costs, DFL is equal to one. Values of one mean no leverage. No fixed costs, no operating leverage. No interest costs, no financial leverage. This should help tie theseformulas to the concepts and help you know when you have the formulas right (or wrong). If you plug in zero for fixed costs, DOL should be one, and if you plug in zero for interest, DFL should be one. ifI Page 52 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #37 - Measures of Leverage The degree of total leverage (DTL) combines the degree of operating leverage and financial leverage. DTL measures the sensitivity of EPS to change in sales. DTL is computed as: DTL==DOLxDFL DTL ==%~EBIT %~sales X DTL= X %~EPS %~EBIT %~EPS %~sales Q(P-V) Q(P-V)-F-I S-TVC DTL=----S-TVC-F-I Example: Degree of total leverage Continuing with our previous example, how much will Atom's EPS increase if Atom increases its sales by 100/0? Answer: From the previous examples: DOLAtom ==1.67 DFLAtom ==1.43 DTL ==DOL x DFL ==1.67 x 1.43 ==2.39 wutsrponmlihgfedcbaVTPONLFDCA Professor's Note: There is some rounding here. If we use 1.6666 for DOL and 1.42857 for DFl, we obtain the DTl 0[2.38. fI Note that we also could have calculated the DTL the long way. From the previous example, the current value of Atom's dollar sales is $4 x 100,000 ==$400,000. S-TVC DTL=----S-TVC-F-I $400,000 - $300,000 = 2.38 $400,000 - $300,000 - $40,000 - $18,000 O/o~EPS ==DTL x %~sales ==2.38 x 100/0 ==23.80/0 EPS will increase by 23.80/0. LOS 37.c: Analyze the effect of financial leverage on a company's net income and return on equity. CFA ® Program Curriculum, Volume 4, page 92 The use of financial leverage significantly increases the risk and potential reward to common stockholders. The following examples involving Beta Company illustrate how financial leverage affects net income and shareholders' return on equity (ROE). ©20 15 Kaplan, Inc. Page 53 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #37 - Measures of Leverage Example 1: Beta Company financed with 1000/0 equity Assume that the Beta Company has $500,000 in assets that are financed with 1000/0 equity. Fixed costs are $120,000. Beta is expected to sell 100,000 units, resulting in operating income of [100,000 ($4 - $2)] - $120,000 = $80,000. Beta's tax rate is 400/0. Calculate Beta's net income and return on equity if its EBIT increases or decreases by 10%. Answer: Beta's Return on Equity With 1000/0 Equity Financing EBlT Less 10% EBIT Interest expense Income before taxes Taxes at 40% Net income Shareholders' equity Return on equity (ROE) $72,000 xutspledcTPLEB Expected EBlT $80,000 0 EBlT Plus 10% $88,000 0 0 $72,000 $80,000 $88,000 28,800 32,000 35,200 $43,200 $48,000 $52,800 $500,000 $500,000 $500,000 8.64% 9.60% 10.56% Example 2: Beta Company financed with 500/0 equity and 500/0 debt Continuing the previous example, assume that Beta Company is financed with 500/0 equity and 500/0 debt. The interest rate on the debt is 60/0. Calculate Beta's net income and return on equity if its EBIT increases or decreases by 100/0. Beta's tax rate is 400/0. Answer: Beta's Return on Equity with 500/0 Equity Financing EBIT Interest expense at 6% Income before taxes Taxes at 40% Net income Shareholders' equity Return on equity (ROE) Page 54 EBlT Less 10% Expected EBlT EBlT Plus 10% $72,000 $80,000 $88,000 15,000 15,000 15,000 $57,000 $65,000 $73,000 22,800 26,000 29,200 $34,200 $39,000 $43,800 $250,000 $250,000 $250,000 13.68% ©2015 Kaplan, Inc. 15.600/0 17.52% Study Session 11 Cross-Reference to CFA Institute Assigned Reading #37 - Measures of Leverage The interest expense associated with using debt represents a fixed cost that reduces net income. However, the lower net income value is spread over a smaller base of shareholders' equity, serving to magnify the ROE. In all three of the scenarios shown in the two examples, ROE is higher using leverage than it is without leverage. Further analyzing the differences between the examples, we can see that the use of financial leverage not only increases the level of ROE, it also increases the rate of change for ROE. In the unleveraged scenario, ROE varies directly with the change in EBIT. For an increase in EBIT of 100/0, the ROE increases from 9.600/0 to 10.560/0, for a rate of change of 100/0. In the leveraged scenario, ROE is more volatile. For an increase in EBIT of 100/0, the ROE increases from 15.600/0 to 17.520/0, for a rate of change of 12.30/0. zywvutsrqponmlihgfedcaVRPONEDCA The use of financial leverage increases the risk of default but also increases the potential return for equity holders. Professor's Note: Recall how this relationship is reflected in the DuPont formula used to analyze ROE. One of the components of the DuPont formula is the equity multiplier (assets/equity), which captures the effect of financial leverage on ROE. LOS 37.d: Calculate the breakeven quantity of sales and determine the company's net income at various sales levels. LOS 37.e: Calculate and interpret the operating breakeven quantity of sales. CPA ® Program Curriculum, Volume 4, page 99 The level of sales that a firm must generate to cover all of its fixed and variable costs is called the breakeven quantity. The breakeven quantity of sales is the quantity of sales for which revenues equal total costs, so that net income is zero. We can calculate the breakeven quantity by simply determining how many units must be sold to just cover total fixed costs. For each unit sold, the contribution margin, which is the difference between price and variable cost per unit, is available to help cover fixed costs. We can thus describe the breakeven quantity of sales, QBE' as: _ fIXedoperating costs + fIXedfinancing costs QBE - . . bl prIce - vana . e cost per urut ©20 15 Kaplan, Inc. Page 55 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #37 - Measures of Leverage Example: Breakeven quantity of sales Consider the prices and costs for Atom Company and Beta Company shown in the following table. Compute and illustrate the breakeven quantity of sales for each company. Operating Costs for Atom Company and Beta Company ytponmeaCBA Atom Company Beta Company Price $4.00 $4.00 Variable costs $3.00 $2.00 Fixed operating costs $10,000 $80,000 Fixed financing costs $30,000 $40,000 Answer: For Atom Company, the breakeven quantity is: QEB Q BE (A tom ) = $10,000 + $30,000 $4.00 - $3.00 = 40 000 , . units Similarly, for Beta Company, the breakeven quantity is: Q BE (Beta ) = $80,000 + $40,000 $4.00 - $2.00 = 60 000 , . unrts The breakeven quantity and the relationship between sales revenue, total costs, net income, and net loss are illustrated in Figures 1 and 2. Figure 1: Breakeven Analysis for Atom Company $ 560 Net Income 480 en (1) :::l c: (1) en (1) en 400 Sales Revenue (Atom) 0.. 320 Total Costs (Atom) c: (1) :.< >~ (1) 0:::;-0 Net Loss @ 160 Breakeven Point 40 Fixed Cost 0 20 40 60 For Atom Company: QBE Page 56 80 = 100 120 ($30,000 + $10,000) / ($4.00 - $3.00) ©20 15 Kaplan, Inc. Sales Units (l,OOOs) = 40,000 units Study Session 11 Cross-Reference to CFA Institute Assigned Reading #37 - Measures of Leverage Figure 2: Breakeven Analysis for Beta Company $ 480 Net Income 400 Sales Revenue (Beta) Total Costs (Beta) Net Loss Breakeven Point Sales Units o 20 40 60 For Beta Company: QBE = 80 100 (l,OOOs)oOEB 120 ($80,000 + $40,000) / ($4.00 - $2.00) = 60,000 units We can also calculate an operating breakeven quantity of sales. In this case, we consider only fixed operating costs and ignore fixed financing costs. The calculation is simply: _ fixed operating costs Q OBE -. . bl . prIce - vana e cost per unit Example: Operating breakeven quantity of sales Calculate the operating breakeven quantity data from the previous example. of sales for Atom and Beta, using the same Answer: For Atom, the operating breakeven quantity $10,000 / ($4.00 - $3.00) For Beta, the operating = 10,000 units breakeven quantity $80,000 / ($4.00 - $2.00) of sales is: of sales is: = 40,000 units We can summarize the effects of leverage on net income through an examination of Figures 1 and 2. Other things equal, a firm that chooses operating and financial structures that result in greater total fixed costs will have a higher breakeven quantity of sales. Leverage of either type magnifies the effects of changes in sales on net income. The further a firm's sales are from its breakeven level of sales, the greater the magnifying effects of leverage on net income. ©20 15 Kaplan, Inc. Page 57 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #37 - Measures of Leverage These same conclusions apply to operating leverage and the operating breakeven quantity of sales. One company may choose a larger scale of operations (larger factory), resulting in a greater operating breakeven quantity of sales and greater leverage, other things equal. Note that the degree of total leverage is calculated for a particular level of sales. The slope of the net income line in Figures 1 and 2 is related to total leverage but is not the same thing. The degree of total leverage is different for every level of sales. Page 58 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #37 - Measures of Leverage LOS 37.a Leverage increases the risk and potential return of a firm's earnings and cash flows. Operating leverage increases with fixed operating costs. Financial leverage increases with fixed financing costs. Sales risk is uncertainty about the firm's sales. Business risk refers to the uncertainty about operating earnings (EBIT) and results from variability in sales and expenses. Business risk is magnified by operating leverage. Financial risk refers to the additional variability of EPS compared to EBIT. Financial risk increases with greater use of fixed cost financing (debt) in a company's capital structure. LOS 37.h Q(P-V) The degree of operating leverage (DOL) is calculated as and is interpreted Q (P-V ) -F %~EBIT as ----. %~sales The degree of financial leverage (DFL) is calculated as EBIT EBIT-I %~EPS an d iIS interprete d as i %~EBIT • The degree of total leverage (DTL) is the combination of operating and financial %~EPS leverage and is calculated as DOL x DFL and interpreted as . %~sales LOS 37.c Using more debt and less equity in a firm's capital structure reduces net income through added interest expense but also reduces net equity. The net effect can be to either increase or decrease ROE. LOS 37.d The breakeven quantity of sales is the amount of sales necessary to produce a net income of zero (total revenue just covers total costs) and can be calculated as: fIXedoperating costs + fIXedfinancing costs price - variable cost per unit Net income at various sales levels can be calculated as total revenue (i.e., price x quantity sold) minus total costs (i.e., total fixed costs plus total variable costs). LOS 37.e The operating breakeven quantity of sales is the amount of sales necessary to produce an operating income of zero (total revenue just covers total operating costs) and can be calculated as: fixed operating costs price - variable cost per unit ©20 15 Kaplan, Inc. Page 59 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #37 - Measures of Leverage 1. Business risk A. operating B. sales risk C. operating is the combination of: risk and financial risk. and financial risk. risk and sales risk. 2. Which of the following is a key determinant of operating leverage? A. Level and cost of debt. B. The competitive nature of the business. C. The trade-off between fixed and variable costs. 3. Which of the following statements about capital structure and leverage is most accurate? A. Financial leverage is directly related to operating leverage. B. Increasing the corporate tax rate will not affect capital structure decisions. C. A firm with low operating leverage has a small proportion of its total costs in fixed costs. 4. Jayco, Inc., sells blue ink for $4 a bottle. The ink's variable cost per bottle is $2. Ink has fixed operating costs of $4,000 and fixed financing costs of $6,000. What is Jayco's breakeven quantity of sales, in units? A. 2,000. B. 3,000. C. 5,000. 5. Jayco, Inc., sells blue ink for $4 a bottle. The ink's variable cost per bottle is $2. Ink has fixed operating costs of $4,000 and fixed financing costs of $6,000. What is Jayco's operating breakeven quantity of sales, in units? A. 2,000. B. 3,000. C. 5,000. 6. If Jayco's sales increase by 100/0,Jayco's EBIT increases by 150/0.If Jayco's EBIT increases by 100/0,Jayco's EPS increases by 120/0.Jayco's degree of operating leverage (DOL) and degree of total leverage (DTL) are closest to: A. 1.2 DOL and 1.5 DTL. B. 1.2 DOL and 2.7 DTL. C. 1.5 DOL and 1.8 DTL. utsromleca Use the following data to answer Questions 7 and 8. Jayco, Inc., sells 10,000 units at a price of $5 per unit. Jayco's fixed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and EBIT is $12,000. 7. Page 60 Jayco's degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to: A. 2.50 DOL and 1.00 DFL. B. 1.67 DOL and 2.00 DFL. C. 1.67 DOL and 1.20 DFL. ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #37 - Measures of Leverage 8. Jayco's degree of total leverage (DTL) is closest to: A. 2.00. B. 1.75. C. 1.50. 9. Vischer Concrete has $1.2 million in assets that are currently financed with 1000/0 equity. Vischer's EBIT is $300,000, and its tax rate is 300/0. IfVischer changes its capital structure (recapitalizes) to include 400/0 debt, what is Vischer's ROE before and after the change? Assume that the interest rate on debt is 50/0. ROE at 1000/0 equity ROE at 600/0 equity A. 17.5% 26.80/0 B. 25.00/0 26.80/0 C. 25.00/0 37.5% tsolec ©20 15 Kaplan, Inc. Page 61 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #37 - Measures of Leverage 1.LCA C Business risk refers to the risk associated with a firm's operating income and is the result of uncertainty about a firm's revenues and the expenditures necessary to produce those revenues. Business risk is the combination of sales risk (the uncertainty associated with the price and quantity of goods and services sold) and operating risk (the leverage created by the use of fixed costs in the firm's operations). 2. C The extent to which costs are fixed determines operating leverage. 3. C If fixed costs are a small percentage of total costs, operating leverage is low. Operating leverage is separate from financial leverage, which depends on the amount of debt in the capital structure. Increasing the tax rate would make the after-tax cost of debt cheaper. 4. C Q = $4, 000 + $6, 000 = 5,000 units BE $4.00 - $2.00 $4,000 5. A QOBE = 6. DOL = 150/0= 1.5 100/0 C $4.00 - $2.00 . = 2, 000 units DFL = 120/0= 1.2 100/0 DTL = DOLxDFL 7. C 8. A = 1.5x1.2 = 1.8 10,000(5 - 3) 6 DO L = "...---Q_.:...( P_V-,-)---:- .,------,;___:.-~ =1 7 [10,000 (5 - 3) - 8,000] . [Q(P- V)-F] DFL = EBIT = 12,000 = 1.2 EBIT - I 12,000 - 2,000 DTL= Q(p-V) [Q(P-V)-F-I] 10,000 (5 - 3) .,-------.:..______;'------~ = 2, or because we [10,000(5 - 3) - 8,000 - 2,000] calculated the components in Question 7, DTL Page 62 = ©2015 Kaplan, Inc. DOL x DFL = 1.67 x 1.2 = 2.0 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #37 - Measures of Leverage 9. A With 100% equity: EBIT $300,000 Interest expense Income before taxes Taxes at 300/0 Net income Shareholder's equity ROE = NI/equity 0 $300,000 90,000 $210,000 $1,200,000 17.50/0 With 600/0 equity: EBIT $300,000 Interest expense ($480,000 at 50/0) Income before taxes Taxes at 300/0 24,000 $276,000 82,800 Net income $193,200 Shareholders' equity $720,000 ROE = NI/equity 26.80/0 ©20 15 Kaplan, Inc. Page 63 The following is a review of the Corporate Finance principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #38.pVUSRNIHEDCBA DIVIDENDS AND SHARE REpURCHASES: BASICS Study Session 11usocXMFEA EXAM Focus Dividends have been a large component of the total returns that stocks have provided over time. Cash dividends and share repurchases are two ways that firms can payout earnings to current shareholders. In this topic review, you will learn the terminology and mechanics of dividend payments. You should also get comfortable with calculating the EPS and book value of a firm after a share repurchase, given the relevant information about the firm and the source of the funds. LOS 38.a: Describe regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on shareholders' wealth and a company's financial ratios. xvutsrponmligedcaVPCA CPA ® Program Curriculum, Volume 4, page 112 Cash dividends, as the name implies, are payments made to shareholders in cash. They come in three forms: 1. Regular dividends occur when a company pays out a portion of profits on a consistent schedule (e.g., quarterly). A long-term record of stable or increasing dividends is widely viewed by investors as a sign of a company's financial stability. 2. Special dividends are used when favorable circumstances allow the firm to make a one-time cash payment to shareholders, in addition to any regular dividends the firm pays. Many cyclical firms (e.g., automakers) will use a special dividend to share profits with shareholders when times are good but maintain the flexibility to conserve cash when profits are down. Other names for special dividends include extra dividends and irregular dividends. 3. Liquidating dividends occur when a company goes out of business and distributes the proceeds to shareholders. For tax purposes, a liquidating dividend is treated as a return of capital and amounts over the investor's tax basis are taxed as capital gains. No matter which form cash dividends take, their net effect is to transfer cash from the company to its shareholders. The payment of a cash dividend reduces a company's assets and the market value of its equity. This means that immediately after a dividend is paid, the price of the stock should drop by the amount of the dividend. For example, if a company's stock price is $25 per share and the company pays $1 per share as a dividend, the price of the stock should immediately drop to $24 per share to account for the lower asset and equity values of the firm. Page 64 ©2015 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics Stock dividends are dividends paid out in new shares of stock rather than cash. In this case, there will be more shares outstanding, but each one will be worth less. Stock dividends are commonly expressed as a percentage. A 200/0stock dividend means every shareholder gets 200/0more stock. On the firm's balance sheet, issuing a stock dividend decreases retained earnings and increases contributed capital by the same amount. Total shareholders' equity remains unchanged. Example: Stock dividend Dwight Craver owns 100 shares of Carson Construction Company at a current price of $30 per share. Carson has 1,000,000 shares of stock outstanding, and its earnings per share (EPS) for the last year were $1.50. Carson declares a 200/0stock dividend to all shareholders of record as of June 30. What is the effect of the stock dividend on the market price of the stock, and what is the impact of the dividend on Craver's ownership position in the company? Answer: Impact of 200/0 Stock Dividend on Shareholders vtronkifedcSDBA Before Stock Dividend After Stock Dividend Shares outstanding 1,000,000 1,000,000 x 1.20 Earnings per share $1.50 $1.50/ Stock price $30.00 $30.00/ Total market value 1,000,000 x $30I Shares owned 100 Ownership value 100 x $30 Ownership stake 100/ 1,000,000 $30,000,000 = 1.20 1.20 $3,000 = 0.01 % 120 x $25 = = 1,200,000 $1.25 = $25.00 1,200,000 x $25 100 x 1.20 = = = $30,000,000 = 120 $3,000 120/ 1,200,000 = 0.010/0 The effect of the stock dividend is to increase the number of shares outstanding by 200/0. However, because company earnings stay the same, EPS decline and the price of the firm's stock drops from $30 to $25. Craver's receipt of more shares is exactly offset by the drop in stock price, and his wealth and ownership position in the company are unchanged. I Stock splits divide each existing share into multiple shares, thus creating more shares. There are now more shares, but the price of each share will drop correspondingly to the number of shares created, so there is no change in the owner's wealth. Splits are expressed as a ratio. In a 3-for-1 stock split, each old share is split into three new shares. Stock splits are more common today than stock dividends. ©20 15 Kaplan, Inc. Page 65 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics Example: Stock split Carson Construction Company declares a 3-for-2 stock split. The current stock price is $30, earnings for last year were $1.50, dividends were $0.60 per share, and there are 1 million shares outstanding. What is the impact on Carson's shares outstanding, stock price, EPS, dividends per share, dividend yield, PIE, and market value? trpolkifecSPIEBA Answer: Impact of a 3-for-2 Stock Split on Shareholders Before Stock Split After Stock Split Shares outstanding 1,000,000 1,000,000 xI (3/2) Stock price $30.00 $30.00 I (3/2) = $20.00 Earnings per share $1.50 $1.50 I (3/2) = $1.00 Dividends per share $0.60 $0.60 I (3/2) = $0.40 Dividend yield $0.60 I $30.00 = 2.0% $0.40 I $20.00 = 2.0% PIE ratio $30.00 I $1.50 = 20 $20.00 I $1.00 = 20 Total market value 1,000,000 x $30 1,500,000 x $20 = $30,000,000 = = 1,500,000 $30,000,000 The number of shares outstanding increases, but the stock price, EPS, and dividends per share decrease by a proportional amount. The dividend yield, PIE ratio, and total market value of the firm remain the same. As in our prior example, the effect on the firm's shareholders also remains the same. The number of shares would increase (100 x 3 12= 150), but the ownership value and stake are unchanged. The bottom line for stock splits and stock dividends is that they increase the total number of shares outstanding, but because the stock price and earnings per share are adjusted proportionally, the value of a shareholder's total shares is unchanged. Some firms use stock splits and stock dividends to keep stock prices within a perceived optimal trading range of $20 to $80 per share. What does academic research have to say about this? • • • • Stock prices tend to rise after a split or stock dividend. Price increases appear to occur because stock splits are taken as a positive signal from management about future earnings. If a report of good earnings does not follow a stock split, prices tend to revert to their original (split-adjusted) levels. Stock splits and dividends tend to reduce liquidity due to higher percentage brokerage fees on lower-priced stocks. The conclusion is that stock splits and stock dividends create more shares but don't increase shareholder value. Page 66 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics Reverse stock splits are the opposite of stock splits. After a reverse split, there are fewer shares outstanding but a higher stock price. Because these factors offset one another, shareholder wealth is unchanged. The logic behind a reverse stock split is that the perceived optimal stock price range is $20 to $80 per share, and most investors consider a stock with a price less than $5 per share less than investment grade. Exchanges may impose a minimum stock price and delist those that fall below that price. A company in financial distress whose stock has fallen dramatically may declare a reverse stock split to increase the stock price. Effects on Financial Ratios Paying a cash dividend decreases assets (cash) and shareholders' equity (retained earnings). Other things equal, the decrease in cash will decrease a company's liquidity ratios and increase its debt-to-assets ratio, while the decrease in shareholders' equity will increase its debt-to-equity ratio. Stock dividends, stock splits, and reverse stock splits have no effect on a company's leverage ratios or liquidity ratios. These transactions do not change the value of a company's assets or shareholders' equity; they merely change the number of equity shares. LOS 38.b: Describe dividend payment chronology, including the significance of declaration, holder-of-record, ex-dividend, and payment dates. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 120 An example of a typical dividend payment schedule is shown in Figure 1. Figure 1: Dividend Payment Chronology Declaration date Ex-dividend date Holder-of-record date August 25 September 15 September 17 • • • • Payment date September 30 Declaration date. The date the board of directors approves payment of the dividend. Ex-dividend date. The first day a share of stock trades without the dividend. The ex-dividend date is also the cutoff date for receiving the dividend and occurs two business days before the holder-of-record date. If you buy the share on or after the ex-dividend date, you will not receive the dividend. Holder-of-record date. The date on which the shareholders of record are designated to receive the dividend. Payment date. The date the dividend checks are mailed out orwhen the payment is electronically transferred to shareholder accounts. ©20 15 Kaplan, Inc. Page 67 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics Stocks are traded ex-dividend on and after the ex-dividend date, so stock prices should fall by the amount of the dividend on the ex-dividend date. Because of taxes, however, the drop in price may be closer to the after-tax value of dividends. yxwvutsrponmlkihgfedcbaVTPNFCA Professor's Note: The reason that the bolder-of-record date is two business days after the ex-dividend date has to do with the fact that the settlement date for stocks is three business days after the trade date (t + 3). If an investor buys a stock the day before the ex-dividend date, the trade will settle three business days later on the bolder-of-record date, and the investor will receive the dividend. fI LOS 38.c: Compare share repurchase methods. CFA® Program Curriculum, Volume 4, page 124 A share repurchase is a transaction in which a company buys back shares of its own common stock. Companies use three methods to repurchase shares: 1. Buy in the open market. Companies may repurchase stock in the open market at the prevailing market price. A share repurchase is authorized by the board of directors for a certain number of shares. Buying in the open market gives the company the flexibility to choose the timing of the transaction. 2. Buy a fixed number of shares at a fixed price. A company may repurchase stock by making a tender offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price. Shareholders may tender their shares according to the terms of the offer. If shareholders try to tender more shares than the total repurchase, the company will typically buy back a pro rata amount from each shareholder. The company may select a tender offer price or use a Dutch auction (described in the Economics topic review for Demand and Supply Analysis: Introduction) to determine the lowest price at which it can repurchase the number of shares desired. 3. Repurchase by direct negotiation. Companies may negotiate directly with a large shareholder to buy back a block of shares, usually at a premium to the market price. A company may engage in direct negotiation in order to keep a large block of shares from coming into the market and reducing the stock price or to repurchase shares from a potential acquirer after an unsuccessful takeover attempt. If the firm pays more than market value for the shares, the result is an increase in wealth for the seller and an equal decrease in wealth for remaining firm shareholders. LOS 38.d: Calculate and compare the effect of a share repurchase on earnings per share when 1) the repurchase is financed with the company's excess cash and 2) the company uses debt to finance the repurchase. CFA® Program Curriculum, Volume 4, page 126 A share repurchase will reduce the number of shares outstanding, which will tend to increase earnings per share. On the other hand, purchasing shares with company funds will reduce interest income and earnings, and purchasing shares with borrowed funds incurs interest costs, which will reduce earnings directly by the after-tax cost of the Page 68 ©2015 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics borrowed funds. The relation of the percentage decrease in earnings and the percentage decrease in the number of shares used to calculate EPS will determine whether the effect of a stock repurchase on EPS will be positive or negative. Before we look at the calculations involved in determining the effect of a share repurchase on EPS, consider the following intuitive approach. The earnings yield for a share of stock is simply EPS divided by the share price. A $20 stock with EPS of $1 has an earnings yield of 5%. If the after-tax yield on company funds used to repurchase shares, or the after-tax cost of borrowed funds used to repurchase shares, is greater than 50/0, EPS will fall as a result of the repurchase. If the after-tax yield on company funds used to repurchase shares, or the after-tax cost of borrowed funds used to repurchase shares, is less than 50/0, EPS will rise as a result of the repurchase. Example: Share repurchase when after-tax cost of debt is less than earnings yield Spencer Pharmaceuticals, Inc., (SPI) plans to borrow $30 million that it will use to repurchase shares. SPI's chief financial officer has compiled the following information: • • • • • • Share price at the time of buyback = $50. Shares outstanding before buyback = 20,000,000. EPS before buyback = $5.00. Earnings yield = $5.00 I $50 = 100/0. After-tax cost of borrowing = 80/0. Planned buyback = 600,000 shares. fX PIE Calculate the EPS after the buyback. Answer: total earnings = $5.00 x 20,000,000 = $100,000,000 f total earnings - after-tax cost of funds EPS a ter b uy b ac k = -----=---------shares outstanding after buyback _ $100,000,000-(600,000 shares X $50 X 0.08) (20,000,000 - 600,000) shares $100,000,000 - $2,400,000 19,400,000 shares $97,600,000 19,400,000 shares = $5.03 Because the 80/0after-tax cost of borrowing is less than the 100/0earnings yield (E/P) of the shares, the share repurchase will increase the company's EPS. ©20 15 Kaplan, Inc. Page 69 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics Example: Share repurchase when after-tax cost of debt is greater than earnings yield Spencer Pharmaceuticals, Inc., (SPI) plans to borrow $30 million that it will use to repurchase shares. Creditors perceive the company to be a significant credit risk, and the after-tax cost of borrowing is 150/0. Using the other information from the previous example, calculate the EPS after the buyback. Answer: EPS aft er b uy b ack = total earnings - after-tax cost of funds shares outstanding after buyback $100,000,000 - (600,000 shares X$50 XO.15) (20,000,000 - 600,000) shares $100,000,000 - $4,500,000 19,400,000 shares $95,500,000 19,400,000 shares = $4.92 Because the after-tax cost of borrowing of 150/0exceeds the earnings yield of 100/0, the added interest paid reduces EPS after the buyback. The conclusion is that a share repurchase using borrowed funds will increase EPS if the after-tax cost of debt used to buy back shares is less than the earnings yield of the shares before the repurchase. It will decrease EPS if the cost of debt is greater than the earnings yield, and it will not change EPS if the two are equal. Page 70 ©2015 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics LOS 38.e: Calculate the effect of a share repurchase on book value per share. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 129 Share repurchases may also have an impact on the book value of a share of stock. Example: Effect of a share repurchase on book value per share The share prices of Blue, Inc., and Red Company are both $25 per share, and each company has 20 million shares outstanding. Both companies have announced a $10 million stock buyback. Blue, Inc., has a book value of $300 million, while Red Company has a book value of $700 million. Calculate the book value per share (BVPS) of each company after the share repurchase. Answer: Share buyback for both companies = $10 million / $25 per share = 400,000 shares. Remaining shares for both companies = 20 million - 400,000 = 19.6 million. Blue, Inc.'s current BVPS = $300 million / 20 million = $15. The market price per share of $25 is greater than the BVPS of $15. Book value after repurchase: $300 million - $10 million = $290 million BVPS = $290 million / 19.6 million = $14.80 BVPS decreased by $0.20 Red Company's current BVPS = $700 million / 20 million = $35. The market price per share of $25 is less than the BVPS of $35. Book value after repurchase: $700 million - $10 million = $690 million BVPS = $690 million / 19.6 million = $35.20 BVPS increased by $0.20 The conclusion is that BVPS will decrease if the repurchase price is greater than the original BVPS and increase if the repurchase price is less than the original BVPS. LOS 38.f: Explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders' wealth, all else being equal. CFA® Program Curriculum, Volume 4, page 130 Because shares are repurchased using a company's own cash, a share repurchase can be considered an alternative to a cash dividend as a way of distributing earnings to shareholders. ©20 15 Kaplan, Inc. Page 71 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics Assuming the tax treatment of the two alternatives is the same, a share repurchase has the same impact on shareholder wealth as a cash dividend payment of an equal amount. Example: Impact of share repurchase and cash dividend of equal amounts Spencer Pharmaceuticals, Inc., (SPI) has 20,000,000 shares outstanding with a current market value of $50 per share. SPI made $100 million in profits for the recent quarter, and because only 700/0of these profits will be reinvested back into the company, SPI's Board of Directors is considering two alternatives for distributing the remaining 300/0 to shareholders: • • Pay a cash dividend of $30,000,000/ 20,000,000 shares = $1.50 per share. Repurchase $30,000,000 worth of common stock. Assume that dividends are received when the shares go ex-dividend, the stock can be repurchased at the market price of $50 per share, and there are no differences in tax treatment between the two alternatives. How would the wealth of an SPI shareholder be affected by the board's decision on the method of distribution? Answer: (1) Cash dividend After the shares go ex-dividend, a shareholder of a single share would have $1.50 in cash and a share worth $50 - $1.50 = $48.50. The ex-dividend value of $48.50 can also be calculated as the market value of equity after the distribution of the $30 million, divided by the number of shares outstanding after the dividend payment: (20,000,000) ($50) - $30,000,000 $4 ...;.__---.:........;.______.:.----= 8.50 20,000,000 total wealth from the ownership of one share = $48.50 + $1.50 = $50 (2) Share repurchase With $30,000,000, SPI could repurchase $30,000,000 / $50 = 600,000 shares of common stock. The share price after the repurchase is calculated as the market value of equity after the $30,000,000 repurchase divided by the shares outstanding after the repurchase: (20,000,000)($50) - $30,000,000 = $970,000,000 = $50 20,000,000 - 600,000 19,400,000 total wealth from the ownership of one share = $50 Page 72 ©2015 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics LOS 38.a Cash dividends are a payment from a company to a shareholder that reduces both the value of the company's assets and the market value of equity. They can come in the forms of regular, special, or liquidating dividends. Stock dividends are distributions of new shares rather than cash. Stock splits divide each existing share into multiple shares. Both create more shares, but there is a proportionate drop in the price per share, so there is no effect on the total value of each shareholder's shares. Other things equal, paying a cash dividend decreases liquidity ratios and increases leverage ratios. Stock dividends and stock splits do not affect liquidity or leverage ratios. LOS 38.h The chronology of a dividend payout is: • Declaration date. • Ex-dividend date. • Holder-of-record date. • Payment date. Stocks purchased on or after the ex-dividend date will not receive the dividend. The ex-dividend date is two business days prior to the holder-of-record date. LOS 38.c Companies can repurchase shares of their own stock by buying shares in the open market, buying back a fixed number of shares at a fixed price through a tender offer, or directly negotiating to buy a large block of shares from a large shareholder. LOS 38.d The effect of share repurchases using borrowed funds on EPS is: • If the company's E/P is equal to the after-tax cost of borrowing, there will be no effect on EPS. • If the company's E/P is greater than the after-tax cost of borrowing, EPS will • Increase. • If the company's E/P is less than the after-tax cost of borrowing, EPS will decrease. PE LOS 38.e The effect of a share repurchase on book value per share is: • An increase if the share price is less than the original BVPS. • A decrease if the share price is greater than the original BVPS. LOS 38.f A share repurchase is economically equivalent to a cash dividend of an equal amount, assuming the tax treatment of the two alternatives is the same. ©20 15 Kaplan, Inc. Page 73 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics Page 74 1. Which of the following is most likely to increase shareholders' wealth? A. A stock dividend. B. A stock split. C. A special dividend. 2. Which of the following is most accurate? The first date on which the purchaser of a stock will not receive a dividend that has been declared is the: A. declaration date. B. ex-dividend date. C. holder-of-record date. 3. A share repurchase that begins with a company communicating to shareholders a specific number of shares and a range of acceptable prices is most likely to be a(n): A. open market repurchase. B. fixed price tender offer. C. Dutch auction. 4. If a company's after-tax borrowing rate is greater than the company's earning yield when the company repurchases stock with borrowed money, going forward, the earnings per share is most likely to: A. increase. B. decrease. C. remain unchanged. 5. After a share repurchase, book value per share is most likely to increase if, prepurchase, BVPS was: A. greater than the market price per share. B. less than the market price per share. C. negative. 6. A company is considering either an open market share repurchase or a cash dividend of an equal amount. Compared to the open market share repurchase, the cash dividend is most likely to: A. increase a shareholder's wealth by a greater amount. B. increase a shareholder's wealth by a lesser amount. C. have a relative impact that depends on the tax treatment of the two alternatives. 7. Studdard Controls recently declared a quarterly dividend of $1.25 payable on Thursday, April 25, to holders of record on Friday, April 12. What is the last day an investor could purchase Studdard stock and still receive the quarterly dividend? A. April 9. B. April 10. C. April 12. yutsromlkieca ©2015 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics 8. Arizona Seafood, Inc., plans $45 million in new borrowing to repurchase 3,600,000 shares at their market price of $12.50. The yield on the new debt will be 120/0.The company has 36 million shares outstanding and EPS of $0.60 before the repurchase. The company's tax rate is 400/0.The company's EPS after the share repurchase will be closest to: A. $0.50. B. $0.57. c. $0.67. tsolec c 9. Northern Financial Co. has a BVPS of $5. The company has announced a $15 million share buyback. The share price is $60 and the company has 40 million shares outstanding. After the share repurchase, the company's BVPS will be closest to: A. $4.65. B. $4.90. C. $5.03. ©20 15 Kaplan, Inc. Page 75 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics 1. C "Special" dividends (also known as "extra" or "irregular" dividends) are likely associated with increased shareholder wealth because they are usually used to excess profits to shareholders after a period of unusually high earnings. Stock and stock splits create more shares; however, there is a proportionate drop in per share, so there is no effect on shareholder wealth. 2. B The chronology of a dividend payout is declaration date, ex-dividend date, holder-ofrecord date, and payment date. The ex-dividend date is the cutoff date for receiving the dividend: stocks purchased on or after the ex-dividend date will not receive the dividend. 3. C Dutch auctions begin with the company communicating to shareholders a specific number of shares and a range of acceptable prices. When companies repurchase shares in the open market, they buy at market prices and in quantities as conditions warrant. In a fixed price tender offer, the company announces a fixed number of shares to be repurchased and a fixed price. 4. B Earnings per share is expected to decrease after a share repurchase if the company's aftertax borrowing rate is greater than the company's earning yield. 5. A Book value per share will increase after a share repurchase if book value per share was greater than market price per share. BVPS will decrease after a share repurchase if BVPS was less than market price. 6. C A share repurchase is economically equivalent to a cash dividend of an equal amount, assuming the tax treatment of the two alternatives is the same. 7. A If an investor purchases shares of stock on or after the ex-dividend date, she will NOT receive the dividend. Therefore, to receive the dividend, the investor must purchase stock the day before the ex-dividend date. The ex-dividend day is always two business days before the holder-of-record date. Two days before April 12 is April 10; therefore, the last day the investor can purchase shares and still receive the dividend is April 9. 8. B Total earnings are $0.60 x 36,000,000 = $21,600,000. After-tax cost of debt is 12% x (1 - 0.40) EPS after buyback = = 7.20/0. total earnings - after-tax cost of funds shares outstanding after buyback $21,600,000 - (3,600,000 shares x$12.50 x 0.072) 36,000,000 shares - 3,600,000 shares EPS Page 76 = $21,600,000 - $3,240,000 $18,360,000 32,400,000 shares 32,400,000 shares $0.57 ©2015 Kaplan, Inc. to be distribute dividends the price Study Session 11 Cross- Reference to CFA Institute Assigned Reading #38 - Dividends and Share Repurchases: Basics 9. A Shares to be repurchased are $15 million / $60 = 250,000 shares. Remaining shares after the repurchase will be 40,000,000 shares. Book value before the repurchase is 40,000,000 x $5.00 Book value after the repurchase will be $200,000,000 BVPS = $185,000,000 / 39,750,000 = - 250,000 = = 39,750,000 $200,000,000. - $15,000,000 = $185,000,000. $4.654 per share. ©20 15 Kaplan, Inc. Page 77 The following is a review of the Corporate Finance principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #39.WTRPONMLKIGECA WORKING CAPITAL MANAGEMENT Study Session 11XMEA EXAM Focus Firm liquidity is an important concern for an analyst, including how a firm manages its working capital, its short-term financing policy, and its sources of short-term financing for liquidity needs. A good portion of this topic review repeats material on ratios and yield calculations from previous topic areas and introduces types of debt securities that will also be covered in the topic reviews for fixed income investments. New concepts introduced here are the management of current assets and liabilities, types of short-term bank financing, and the receivables aging schedule. Understand well why the management of inventory, receivables, and payables is important to a firm's overall profitability and value. The general guidelines for establishing and evaluating a firm's short-term investment policies and for evaluating short-term funding strategy and policy should be sufficient here. Focus on the overall objectives and how they can be met. LOS 39.a: Describe primary and secondary sources of liquidity and factors that influence a company's liquidity position. wutsrponmlihgfedcbaVPCA CPA ® Program Curriculum, Volume 4, page 143 A company's primary sources of liquidity are the sources of cash it uses in its normal day-to-day operations. The company's cash balances result from selling goods and services, collecting receivables, and generating cash from other sources such as short-term investments. Typical sources of short-term funding include trade credit from vendors and lines of credit from banks. Effective cashflow management of a firm's collections and payments can also be a source of liquidity for a company. Secondary sources of liquidity include liquidating short-term or long-lived assets, negotiating debt agreements (i.e., renegotiating), or filing for bankruptcy and reorganizing the company. While using its primary sources of liquidity is unlikely to change the company's normal operations, resorting to secondary sources of liquidity such as these can change the company's financial structure and operations significantly and may indicate that its financial position is deteriorating. Factors That Influence a Company's Liquidity Position In general, a company's liquidity position improves if it can get cash to flow in more quickly and flow out more slowly. Factors that weaken a company's liquidity position are called drags and pulls on liquidity. Page 78 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management Drags on liquidity delay or reduce cash inflows, or increase borrowing costs. Examples include uncollected receivables and bad debts, obsolete inventory (takes longer to sell and can require sharp price discounts), and tight short-term credit due to economic conditions. Pulls on liquidity accelerate cash outflows. Examples include paying vendors sooner than is optimal and changes in credit terms that require repayment of outstanding balances. LOS 39.h: Compare a company's liquidity measures with those of peer • companIes. vutsrqponmlkigedcbaVPFCA CFA® Program Curriculum, Volume 4, page 145 Some companies tend to have chronically weak liquidity positions, often due to specific factors that affect the company or its industry. These companies typically need to borrow against their long-lived assets to acquire working capital. Liquidity ratios are employed by analysts to determine the firm's ability to pay its shortterm liabilities. • The current ratio is the best-known measure of liquidity: • current assets current rano = ------current liabilities The higher the current ratio, the more likely it is that the company will be able to pay its short-term bills. A current ratio of less than one means that the company has negative working capital and is probably facing a liquidity crisis. Working capital equals current assets minus current liabilities. • The quick ratio or acid-test ratio is a more stringent measure of liquidity because it does not include inventories and other assets that might not be very liquid: . k . cash + short-term marketable securities + receivables qUlc rano = current liabilities The higher the quick ratio, the more likely it is that the company will be able to pay its short-term bills. The current and quick ratios differ only in the assumed liquidity of the current assets that the analyst projects will be used to payoff current liabilities. • A measure of accounts receivable liquidity is the receivables turnover: credit sales receivables turnover == ------average receivables It is considered desirable to have a receivables turnover figure close to the industry norm. ©20 15 Kaplan, Inc. Page 79 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital ManagementyxwvutsrponmlkihgfedcbaWTPNIFA Professor's Note: This formula for the receivables turnover ratio uses credit sales in the numerator, rather than total sales as shown in the earlier topic review on ratio analysis. While an analyst within a company will know what proportion of sales are credit or cash sales, an external analyst will likely not have this information but may be able to estimate it based on standard industry practice. In most cases when a ratio compares a balance sheet account (such as receivables) with an income or cashflow item (such as sales), the balance sheet item will be the average of the account instead of simply the end-of year balance. Averages are calculated by adding the beginning-of year account value and the end-of year account value, then dividing the sum by two. • The inverse of the receivables turnover multiplied by 365 si the number of days of receivables (also called average days'sales outstanding), which is the average number of days it takes for the company's customers to pay their bills: number of days of receivables = sA 365 receivables turnover average receivables average day's credit sales It is considered desirable to have a collection period (and receivables turnover) close to the industry norm. The firm's credit terms are another important benchmark used to interpret this ratio. A collection period that is too high might mean that customers are too slow in paying their bills, which means too much capital is tied up in assets. A collection period that is too low might indicate that the firm's credit policy is too rigorous, which might be hampering sales. • Ameasure of a firm's efficiency with respect to its processing and inventory management is the inventory turnover: . cost of goods sold Inventory turnover = --____;::;...---average Inventory Professor's Note: Pay careful attention to the numerator in the turnover ratios. For inventory turnover, be sure to use cost of goods sold, not sales. • The inverse of the inventory turnover multiplied by 365 is ht e average inventory processing period or number of days of inventory: 365 number of days of inventory = -.------mventory turnover • average Inventory average day's COGS As is the case with accounts receivable, it is considered desirable to have an inventory processing period (and inventory turnover) close to the industry norm. A processing period that is too high might mean that too much capital is tied up in inventory and could mean that the inventory is obsolete. A processing period that is too low might indicate that the firm has inadequate stock on hand, which could hurt sales. Page 80 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management • A measure of the use of trade credit by the firm is thepayables turnover ratio: yvutsrponmlihgfedcbaVPFCA . purchases payables turnover ratio = ---=-----average trade payables • The inverse of the payables turnover ratio multiplied by 365 is the payables payment period or number of days of payables, which is the average amount of time it takes the company to pay its bills: number of days of payables = 365 average payables . payables turnover rano average day's purchases LOS 39.c: Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company's effectiveness with that of peer companies. CFA ® Program Curriculum, Volume 4, page 149 • The operating cycle, the average number of days that it takes to turn raw materials into cash proceeds from sales, is: operating cycle = days of inventory + days of receivables • The cash conversion cycle or net operating cycle is the length of time it takes to turn the firm's cash investment in inventory back into cash, in the form of collections from the sales of that inventory. The cash conversion cycle is computed from the average receivables collection period, average inventory processing period, and the payables payment period: average days cash conversion cycle = of receivables + average days of inventory average days of payables High cash conversion cycles are considered undesirable. A conversion cycle that is too high implies that the company has an excessive amount of investment in working capital. LOS 39.d: Describe how different types of cash flows affect a company's net daily cash position. CFA® Program Curriculum, Volume 4, page 150 Daily cash position refers to uninvested cash balances a firm has available to make routine purchases and pay expenses as they come due. The purpose of managing a firm's daily cash position is to have sufficient cash on hand (that is, make sure the firm's net ©20 15 Kaplan, Inc. Page 81 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management daily cash position never becomes negative) but to avoid keeping excess cash because of the interest income foregone by not investing the cash. Typical cash inflows for a firm include its cash from sales and collections of receivables; cash received from subsidiaries; dividends, interest, and principal received from investments in securities; tax refunds; and borrowing. Typical cash outflows include payments to employees and vendors; cash transferred to subsidiaries; payments of interest and principal on debt; investments in securities; taxes paid; and dividends paid. To manage its cash position effectively, a firm should analyze its typical cash inflows and outflows by category and prepare forecasts over short-term (daily or weekly balances for the next several weeks), medium-term (monthly balances for the next year), and long-term time horizons. A firm can use these forecasts to identify periods when its cash balance may become low enough to require short-term borrowing, or high enough to invest excess cash in short-term securities. LOS 39.e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company's short-term investment policy guidelines. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 155 Short-term securities in which a firm can invest cash include: • • • • • • • • • u.S. Treasury bills. Short-term federal agency securities. Bank certificates of deposit. Banker's acceptances. Time deposits. Repurchase agreements. Commercial paper. Money market mutual funds. Adjustable-rate preferred stock. Adjustable-rate preferred stock has a dividend rate that is reset quarterly to current market yields and offers corporate holders a tax advantage because a percentage of the dividends received are exempt from federal tax. The other securities listed are all described in more detail in the topic reviews on fixed income securities. We covered the yield calculations for short-term discount securities in the "Discounted Cash Flow Applications" topic review in Quantitative Methods. The percentage discount from face value is: 0/0 discount Page 82 = face value - price face value ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management The discount-basis yield (bank discount yield or BDy) is: discount-basis yield ;::: face value - price 360 ;:::% discount x 360 xX face value days days The money market yield is: 360 days = holding period yield X 360 days where: "days" ;:::days to maturity "price" ;:::purchase price of the security The bond equivalent yield measure for short-term discount securities is calculated as: bond equivalent yield = face value - price 365 prIce days to maturity . = holding period yield X 365 days ywvutsrqonmlihfedcbaQPNMI Professor'sNote: In Quantitative Methods, the bond equivalent yield was defined differently as two times the effective semiannual yield. Returns on the firm's short-term securities investments should be stated as bond equivalent yields. The return on the portfolio should be expressed as a weighted average of these yields. Cash Management Investment Policy Typically, the objective of cash management is to earn a market return without taking on much risk, either liquidity risk or default risk. Firms invest cash that may be needed in the short term in securities of relatively high credit quality and relatively short maturities to minimize these risks. It is advisable to have a written investment policy statement. An investment policy statement typically begins with a statement of the purpose and objective of the investment portfolio, some general guidelines about the strategy to be employed to achieve those objectives, and the types of securities that will be used. The investment policy statement will also include specific information on who is allowed to purchase securities, who is responsible for complying with company guidelines, and what steps will be taken if the investment guidelines are not followed. Finally, the investment policy statement will include limitations on the specific types of securities permitted for investment of short-term funds, limitations on the credit ratings of portfolio securities, ©20 15 Kaplan, Inc. Page 83 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management and limitations on the proportions of the total short-term securities portfolio that can be invested in the various types of permitted securities. An investment policy statement should be evaluated on how well the policy can be expected to satisfy the goals and purpose of short-term investments, generating yield without taking on excessive credit or liquidity risk. The policy should not be overly restrictive in the context of meeting the goals of safety and liquidity. LOS 39.f: Evaluate a company's management of accounts receivable, inventory, and accounts payable over time and compared to peer companies. ywvutsrponmlihgedcaVPOMFDCA CFA® Program Curriculum, Volume 4, page 161 The management of accounts receivable begins with calculating the average days of receivables and comparing this ratio to the firm's historical performance or to the average ratios for a group of comparable companies. More detail about the accounts receivable performance can be gained by using an aging schedule such as that presented in Figure 1. Figure 1: Receivables Aging (thousands of dollars) Days Outstanding March April May < 31 days 200 212 195 31-60 days 150 165 140 61-90 days 100 90 92 > 90 days 50 70 66 nA In March, $200,000 of accounts receivable were current-that is, had been outstanding less than 31 days; $50,000 of the receivables at the end of March had been outstanding for more than 90 days. Presenting this data as percentages of total outstanding receivables can facilitate analysis of how the aging schedule for receivables is changing over time. An example is presented in Figure 2. Figure 2: Receivables Aging (0/0 of totals) Days Outstanding March April May < 31 days 40% 39% 40% 31-60 days 30% 31% 28% 61-90 days 20% 17% 19% > 90 days 10% 13% 13% Another useful metric for monitoring the accounts receivable performance is the weighted average collection period, which indicates the average days outstanding per Page 84 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management dollar of receivables. As illustrated in Figure 3, the weights are the percentage of total receivables in each category, and these are multiplied by the average days to collect accounts within each aging category. Figure 3: Weighted Average Collection Period-March yvutsronlihgedcaWODCA Average Collection Days % Weight < 31 days 22 40% 8.8 31-60 days 44 30% 13.2 61-90 days 74 20% 14.8 > 90 days 135 10% 13.5 Days Outstanding Weighted Average Collection Period Days x x Weight 50.3 days The information necessary to compare a firm's aging schedule and weighted average collection period to other firms is not available. However, analysis of the historical trends and significant changes in a firm's aging schedule and weighted average collection days can give a clearer picture of what is driving changes in the simpler metric of average days of receivables. The company must always evaluate the trade-off between stricter credit terms (and borrower creditworthiness) and the ability to make sales. Terms that are too strict will lead to less-than-optimal sales. Terms that are too lenient will increase sales at the cost of longer average days of receivables, which must be funded at some cost, and will increase bad accounts, directly affecting profitability. Inventory Management Inventory management involves a trade-off as well. Inventory levels that are too low will result in lost sales due to stock-outs, while inventory that is too large will have carrying costs because the firm's capital is tied up in inventory. Reducing inventory will free up cash that can be invested in interest-bearing securities or used to reduce debt or equity funding. Increasing average days' inventory or a decreasing inventory turnover ratio can both indicate that inventory is too large. A large inventory can lead to greater losses from obsolete items and can also indicate that obsolete items that no longer sell well are included in inventory. Comparing average days of inventory and inventory turnover ratios between industries, or even between two firms that have different business strategies, can be misleading. The grocery business typically has high inventory turnover, while an art gallery's inventory turnover will typically be low. An auto parts firm that stocks hard-to-find parts for antique cars will likely have a low inventory turnover (and charge premium prices) compared to a chain auto parts store that does most of its business in standard items like oil filters, brake parts, and antifreeze. In any business, inventory management is an important component of effective overall financial management. ©20 15 Kaplan, Inc. Page 85 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management Accounts Payable Management Just as a company must manage its receivables because they require working capital (and therefore have a funding cost), payables must be managed well because they represent a source of working capital to the firm. If the firm pays its payables prior to their due dates, cash is used unnecessarily and interest on it is sacrificed. If a firm pays its payables late, it can damage relationships with suppliers and lead to more restrictive credit terms or even the requirement that purchases be made for cash. Late payment can also result in interest charges that are high compared to other sources of short-term financing. Typical terms on payables (trade credit) contain a discount available to those who pay quickly as well as a due date. Terms of "2/1 0 net 60" mean that if the invoice is paid within ten days, the company gets a 20/0 discount on the invoiced amount and that if the company does not take advantage of the discount, the net amount is due 60 days from the date of the invoice. The cost to the company of not taking the discount for early payment can be evaluated as an annualized rate: 365 1+ % discount days past discount -1 cost of trade credit = 1- % discount where: days past discount = number of days after the end of the discount period zywvutsrponmlkihgfedcaYTQPNM Professor's Note: You should recognize this from Quantitative Methods as the formula for converting a short-term rate to an effective annual rate. The term [% discount / (1 - % discount)) is the holding period return to the firm of taking advantage of a discount, in the same way that the holding period return on a pure discount security is [discount / (face - discount)). Trade credit can be a source of liquidity for a company. However, when the cost of trade credit is greater than the company's cost of short-term liquidity from other sources, the company is better off paying the invoice within (ideally at the end of) the discount period. Example: Cost of trade credit Calculate and interpret the annualized cost of trade credit for invoice terms of 2/1 0 net 60, when the invoice is paid on the 40th, 50th, or 60th day. Page 86 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management Answer: The discount is 20/0.The annualized cost of not taking the discount can be calculated when the invoice is paid on: 365 / 0.02 '140-10 Day 40: 1+---1=27.90/0 1-0.02 365 / 0.02 '150-10 Day 50: 1+---1 = 20.20/0 '- 1-0.02.1 365 / 0.02 '160-10 Day 60: 1+ ---1 = 15.90/0 1-0.02 nA urpomligecaVPFCA The annualized cost of trade credit decreases as the payment period increases. If the company does not take the 20/0discount within the first ten days, it should wait until the due date (day 60) to pay the invoice. Our primary quantitative measure of payables management is average days of payables outstanding, which can also be calculated as: number of days of payables = accounts payable average day's purchases where: average day's purchases = annual purchases 365 A company with a short payables period (high payables turnover) may simply be taking advantage of discounts for paying early because it has good low-cost funds available to finance its working capital needs. A company with a long payables period may be such an important buyer that it can effectively utilize accounts payable as a source of short-term funding with relatively little cost (because suppliers will put up with it). Monitoring the changes in days' payables outstanding over time for a single firm will, however, aid the analyst. An extension of days' payables may serve as an early warning of deteriorating short-term liquidity. LOS 39.g: Evaluate the choices of short-term and recommend a financing funding available to a company method. CFA® Program Curriculum, Volume 4, page 175 There are several sources of short-term funding available to a company, from both bank and non-bank sources. We list the most important of these here. ©20 15 Kaplan, Inc. Page 87 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management Sources of Short-Term Funding From Banks Lines of credit are used primarily by large, financially sound companies. • • • vutsrponmlkigfedcbaURC Uncommitted line of credit.A bank extends an offer of credit for a certain amount but may refuse to lend if circumstances change. Committed (regular) line of credit. A bank extends an offer of credit that it "commits to" for some period of time. The fact that the bank has committed to extend credit in amounts up to the credit line makes this a more reliable source of short-term funding than an uncommitted line of credit. Banks charge a fee for making such a commitment. Loans under the agreement are typically for periods of less than a year, and interest charges are stated in terms of a short-term reference rate, such as LIBOR or the u.s. prime rate, plus a margin to compensate for the credit risk of the loan. Outside the United States, similar arrangements are referred to as overdraft lines of credit. Revolving line of credit. An even more reliable source of short-term financing than a committed line of credit, revolving lines of credit are typically for longer terms, sometimes as long as years. Along with committed lines of credit, revolving credit lines can be verified and can be listed on a firm's financial statements in the footnotes as a source of liquidity. nA Companies with weaker credit may have to pledge assets as collateral for bank borrowings. Fixed assets, inventory, and accounts receivable may all serve as collateral for loans. Short-term financing is typically collateralized by receivables or inventory and longer-term loans are secured with a claim to fixed (longer-term) assets. The bank may also have a blanket lien which gives it a claim to all current and future firm assets as collateral in case the primary collateral is insufficient and the borrowing firm defaults. When a firm assigns its receivables to the bank making a loan, the company still services the receivables and remains responsible for any receivables that are not paid. Banker's acceptances are used by firms that export goods. A banker's acceptance is a guarantee from the bank of the firm that has ordered the goods stating that a payment will be made upon receipt of the goods. The exporting company can then sell this acceptance at a discount in order to generate immediate funds. Factoring refers to the actual sale of receivables at a discount from their face values. The size of the discount will depend on how long it is until the receivables are due, the creditworthiness of the firm's credit customers, and the firm's collection history on its receivables. The "factor" (the buyer of the receivables) takes on the responsibility for collecting receivables and the credit risk of the receivables portfolio. Non-Bank Sources of Short-Term Funding Smaller firms and firms with poor credit may use nonbank finance companies for shortterm funding. The cost of such funding is higher than other sources and is used by firms for which normal bank sources of short-term funding are not available. Large, creditworthy companies can issue short-term debt securities called commercial paper. Whether the firm sells the paper directly to investors (direct placement) or sells it Page 88 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management through dealers (dealer-placed paper), the interest costs are typically slightly less than the rate they could get from a bank. In managing its short-term financing, a firm should focus on the objectives of having sufficient sources of funding for current, as well as future foreseeable, cash needs and should seek the most cost-effective rates available given its needs, assets, and creditworthiness. The firm should have the ability to prepay short-term borrowings when cash flow permits and have the flexibility to structure its short-term financing so that the debt matures without peaks and can be matched to expected cash flows. For large borrowers, it is important that the firm has alternative sources of short-term funding and even alternative lenders for a particular type of financing. It is often worth having slightly higher overall short-term funding costs in order to have flexibility and redundant sources of financing. ©20 15 Kaplan, Inc. Page 89 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management LOS 39.a Primary sources of liquidity are the sources of cash a company uses in its normal operations. If its primary sources are inadequate, a company can use secondary sources of liquidity such as asset sales, debt renegotiation, and bankruptcy reorganization. A company's liquidity position depends on the effectiveness of its cash flow management and is influenced by drags on its cash inflows (e.g., uncollected receivables, obsolete inventory) and pulls on its cash outflows (e.g., early payments to vendors, reductions in credi t limits). LOS 39.h Measures of a company's short-term liquidity include: • Current ratio » current assets / current liabilities. • Quick ratio « (cash + marketable securities + receivables) / current liabilities. Measures of how well a company is managing its working capital include: • Receivables turnover « credit sales / average receivables. • Number of days of receivables » 365 / receivables turnover. • Inventory turnover » cost of goods sold / average inventory. • Number of days of inventory » 365 / inventory turnover. • Payables turnover » purchases / average trade payables. • Number of days of payables ;:::365 / payables turnover. LOS 39.c The operating cycle and the cash conversion cycle are summary measures of the effectiveness of a company's working capital management. • Operating cycle ;:::days of inventory + days of receivables. • Cash conversion cycle« days of inventory + days of receivables - days of payables. Operating and cash conversion cycles that are high relative to a company's peers suggest the company has too much cash tied up in working capital. LOS 39.d To manage its net daily cash position, a firm needs to forecast its cash inflows and outflows and identify periods when its cash balance may be lower than needed or higher than desired. Cash inflows include operating receipts, cash from subsidiaries, cash received from securities investments, tax refunds, and borrowing. Cash outflows include purchases, payroll, cash transfers to subsidiaries, interest and principal paid on debt, investments in securities, taxes paid, and dividends paid. Page 90 ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management LOS 39.e Commonly used annualized yields for short-term pure discount securities are based on the days to maturity (days) of the securities and include: • Discount-basis yields « % discount from face value x (360/days). • Money market yields « HPY x (360/days). • Bond-equivalent yields « HPY x (365/days). The overall objective of short-term cash management is to earn a reasonable return while taking on only very limited credit and liquidity risk. Returns on the firm's short-term securities investments should be stated as bond equivalent yields. The return on the portfolio should be expressed as a weighted average of these yields. An investment policy statement should include the objectives of the cash management program, details of who is authorized to purchase securities, authorization for the purchase of specific types of securities, limitations on portfolio proportions of each type, and procedures in the event that guidelines are violated. LOS 39.f A firm's inventory, receivables, and payables management can be evaluated by comparing days of inventory, days of receivables, and days of payables for the firm over time and by comparing them to industry averages or averages for a group of peer companies. A receivables aging schedule and a schedule of weighted average days of receivables can each provide additional detail for evaluating receivables management. LOS 39.g There are many choices for short-term borrowing. The firm should keep costs down while also allowing for future flexibility and alternative sources. The choice of short-term funding sources depends on a firm's size and creditworthiness. Sources available, in order of decreasing firm creditworthiness and increasing cost, include: • Commercial paper. • Bank lines of credit. • Collateralized borrowing. • Nonbank financing. • Factoring. ©20 15 Kaplan, Inc. Page 91 Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management 1. Firm A and Firm B have the same quick ratio, but Firm A has a greater current ratio than Firm B. Compared to Firm B, it is most likely that Firm A has: A. greater inventory. B. greater payables. C. a higher receivables turnover ratio. yutsromlkieca 2. An increase in Rowley Corp's cash conversion cycle and a decrease in Rowley's operating cycle could result from: Cash conversion cycle T Operating cycle 1 A. Decreased receivables turnover Increased payables turnover B. Decreased receivables turnover Decrease in days of inventory C. Increased inventory turnover Increased payables turnover T Page 92 3. An A. B. C. 4. Which of the following statements most accurately describes a key aspect of managing a firm's net daily cash position? A. Analyze cash inflows and outflows to forecast future needs for cash. B. Maximize the firm's cash inflows and minimize its cash outflows. C. Minimize uninvested cash balances because they earn a return of zero. 5. Boyle, Inc., just purchased a banker's acceptance for $25,400. It will mature in 80 days for $26,500. The discount-basis yield and the bond equivalent yield for this security are closest to: Discount-basis Bond equivalent A. 18.70/0 18.70/0 19.8% B. 18.70/0 C. 4.20/0 19.80/0 6. Chapmin Corp. is a large domestic services firm with a good credit rating. The source of short-term financing it would most likely use is: A. factoring of receivables. B. issuing commercial paper. C. issuing bankers' acceptances. example of liquidating negotiating short-term a primary source of liquidity is: assets. debt contracts. investment portfolios. ©2015 Kaplan, Inc. Study Session 11 Cross-Reference to CFA Institute Assigned Reading #39 - Working Capital Management 1. A Inventory is in the numerator of the current ratio but not in the quick ratio. Greater inventory for Firm A is consistent with a greater current ratio for Firm A. 2. B A decrease in receivables turnover would increase days of receivables and increase the cash conversion cycle. A decrease in days of inventory would decrease the operating cycle. 3. C Primary sources of liquidity include ready cash balances, short-term funds (e.g., short-term investment portfolios), and cash flow management. Secondary sources of liquidity include negotiating debt contracts, liquidating assets, and filing for bankruptcy protection and reorganization. 4. A The goal of managing the net daily cash position is to ensure that adequate cash is available to prevent the firm from having to arrange financing on short notice (and thus at high cost), while earning a return on cash balances when they are temporarily high by investing in short-term securities. A firm can meet this goal by forecasting its cash inflows and outflows to identify periods when its cash balance is expected to be lower or higher than needed. "Minimizing uninvested cash balances" is inaccurate because a firm should maintain some target amount of available cash. 5. B The actual discount on the acceptance is (26,500 - 25,400) /26,500 = 4.1510/0. The annualized discount, or discount-basis yield, is 4.151 (360/80) = 18.680/0. The holding period yield is (26,500 - 25,400) / 25,400 yield is 4.331(365/80) = 19.76%. 6. B = 4.3310/0. The bond equivalent Large firms with good credit have access to the commercial paper market and can get lower financing costs with commercial paper than they can with bank borrowing. Bankers' acceptances are used by companies involved in international trade. Factoring of receivables is a higher-cost source of funds and is used more by smaller firms that do not have particularly strong credit. ©20 15 Kaplan, Inc. Page 93 The following is a review of the Corporate Finance principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #40.VUTSRPONMLIHGFEDCA THE CORPORATE GOVERNANCE OF LISTED COMPANIES: A A MANUAL FOR INVESTORS Study Session 11XMEA EXAM Focus Due to the collapses of some major corporations and associated investor losses, corporate governance has become a hot topic in the investment community. The prominence of the issue has likely been a factor in the decision to include this topic in the curriculum. Corporate governance encompasses the internal controls that outline how a firm is managed. The material here is not particularly challenging, but given all the lists of "things to consider" in the CFA curriculum concerning corporate governance, we have not covered them all here. You need to understand the specific issues that are covered under the heading of "corporate governance" and which practices are considered good. You should know the characteristics of an independent and effective board of directors. Much of the rest of the material has to do with shareholder interests and whether a firm's actions and procedures promote the interests of shareholders. LOS 40.a: Define corporate governance. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 192 Corporate governance is the set of internal controls, processes, and procedures by which firms are managed. It defines the appropriate rights, roles, and responsibilities of management, the board of directors, and shareholders within an organization. It is the firm's checks and balances. Good corporate governance practices seek to ensure that: • • • • • • Page 94 The board of directors protects shareholder interests. The firm acts lawfully and ethically in dealings with shareholders. The rights of shareholders are protected and shareholders have a voice in governance. The board acts independently from management. Proper procedures and controls cover management's day-to-day operations. The firm's financial, operating, and governance activities are reported to shareholders in a fair, accurate, and timely manner. ©20 15 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors LOS 40.b: Describe practices related to board and committee independence, experience, compensation, external consultants, and frequency of elections and determine whether they are supportive of shareowner protection. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 198 The duty of the board is to act in the shareholders' long-term interests. An effective board needs to have the independence, experience, and resources necessary to perform this duty. To properly protect their long-term interests as shareholders, investors should consider whether the following statements hold true: nA • • • • • A majority of the board of directors is comprised of independent members (not management) . The board meets regularly outside the presence of management. The chairman of the board is also the CEO or a former CEO of the firm. This may impair the ability and willingness of independent board members to express opinions contrary to those of management. Independent board members have a primary or leading board member in cases where the chairman is not independent. Board members are closely aligned with a firm supplier, customer, share-option plan, or pension adviser. Can board members recuse themselves on any potential areas of conflict? An independent board is less likely to make decisions that unfairly or improperly benefit management and those who have influence over management. There is often a need for specific, specialized, independent advice on various firm issues and risks, including compensation; mergers and acquisitions; legal, regulatory, and financial matters; and issues relating to the firm's reputation. A truly independent board will have the ability to hire external consultants without management approval. This enables the board to receive specialized advice on technical issues and provides the board with independent advice that is not influenced by management interests. Frequency of Board Elections Anything that prevents shareholders from being able to approve or reject board members annually limits shareowners' abilities to change the board's composition if board members fail to represent shareowners' interests fairly. While reviewing firm policy regarding election of the board, investors should consider: • • • • Whether there are annual elections or staggered multiple-year terms (a classified board). A classified board may serve another purpose-to act as a takeover defense. Whether the board filled a vacant position for a remaining et rm without shareholder approval. Whether shareholders can remove a board member. Whether the board is the proper size for the specific facts and circumstances of the firm. ©20 15 Kaplan, Inc. Page 95 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors LOS 40.c: Describe board independence and explain the importance of independent board members in corporate governance. urpomligecaVPFCA CFA ® Program Curriculum, Volume 4, page 198 A board can be considered independent if its decisions are not controlled or biased by the management of the firm. Although the definition of independence may vary across firms, typically to be considered independent, a board member must not have any material business or other relationship with: • • • • • The firm and its subsidiaries, including former employees, executives, and their families. Individuals or groups, such as a shareholder(s) with a controlling interest, which can influence the firm's management. Executive management and their families. The firm's advisers, auditors, and their families. Any entity which has a cross directorship with the firm. An independent board member must work to protect shareholders' long-term interests. Board members need to have not only independence, but experience and resources. The board of directors must have autonomy to operate independently from management. If board members are not independent, they may be more likely to make decisions that benefit either management or those who have influence over management, thus harming shareholders' long-term interests. To make sure board members act independently, the firm should have policies in place to discourage board members from receiving consulting fees for work done on the firm's behalf or receiving finders' fees for bringing mergers, acquisitions, and sales to management's attention. Further, procedures should limit board members' and associates' ability to receive compensation beyond the scope of their board responsibilities. The firm should disclose all material related-party transactions or commercial relationships it has with board members or nominees. The same goes for any property that is leased, loaned, or otherwise provided to the firm by board members or executive officers. Receiving personal benefits from the firm can create conflicts of interest. LOS 40.d: Identify factors that an analyst should consider when evaluating the qualifications of board members. CFA ® Program Curriculum, Volume 4, page 200 Board members without the requisite skills and experience are more likely to defer to management when making decisions. This can be a threat to shareholder interests. When evaluating the qualifications of board members, consider whether board members: • • Page 96 Can make informed decisions about the firm's future. Can act with care and competence as a result of their experience with: • Technologies, products, and services which the firm offers. ©20 15 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors • • • • • • • • Financial operations and accounting and auditing topics. • Legal issues. • Strategies and planning. • Business risks the firm faces. Have made any public statements indicating their ethical stances. Have had any legal or regulatory problems as a result of working for or serving on the firm's board or the board of another firm. Have other board experience. Regularly attend meetings. Are committed to shareholders. Do they have significant stock positions? Have they eliminated any conflicts of interest? Have necessary experience and qualifications. Have served on the board for more than ten years. While this adds experience, these board members may be too closely allied with management. Investors should also consider how many board and committee meetings are held, and the attendance record of the meetings; whether the board and its committees conduct self-assessments; and whether the board provides adequate training for its members. LOS 40.e: Describe responsibilities of the audit, compensation, and nominations committees and identify factors an investor should consider when evaluating the quality of each committee. urpomligecaVPCA CPA ® Program Curriculum, Volume 4, page 204 Board committees are responsible for examining specific issues and reporting to the board, which is responsible for making final decisions. Audit Committee This committee ensures that the financial information provided to shareholders is complete, accurate, reliable, relevant, and timely. Investors must determine whether: • • • • • • • • • Proper accounting and auditing procedures have been followed. The external auditor is free from management influence. Any conflicts between the external auditor and the firm areresolved in a manner that favors the shareholder. Independent auditors have authority over the audit of all ht e company's affiliates and divisions. All board members serving on the audit committee are independent. Committee members are financial experts. The shareholders vote on the approval of the board's selection of the external auditor. The audit committee has authority to approve or reject any proposed non-audit engagements with the external audit firm. The firm has provisions and procedures that specify to whom the internal auditor reports. Internal auditors must have no restrictions on their contact with the audit • committee. ©20 15 Kaplan, Inc. Page 97 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors • • There have been any discussions between the audit committee and the external auditor resulting in a change in financial reports due to questionable interpretation of accounting rules, fraud, and the like. The audit committee controls the audit budget. Remuneration/Compensation Committee Investors should be sure a committee of independent board members sets executive compensation, commensurate with responsibilities and performance. The committee can further these goals by making sure all committee members are independent and by linking compensation to long-term firm performance and profitability. Investors, when analyzing this committee, should determine whether: • • • • • • • • • Executive compensation is appropriate. The firm has provided loans or the use of company property toboard members. Committee members attend regularly. Policies and procedures for this committee are in place. The firm has provided details to shareholders regarding compensation in public documents. Terms and conditions of options granted are reasonable. Any obligations regarding share-based compensation are met through issuance of new shares. The firm and the board are required to receive shareholder approval for any sharebased remuneration plans, because these plans can create potential dilution issues. Senior executives from other firms have cross-directorship links with the firm or committee members. Watch for situations where individuals may benefit directly from reciprocal decisions on board compensation. Nominations Committee The nominations committee handles recruiting of new (independent) board members. It is responsible for: • • • • Recruiting qualified board members. Regularly reviewing performance, independence, skills,and experience of existing board members. Creating nomination procedures and policies. Preparing an executive management succession plan. Candidates proposed by this committee will affect whether or not the board works for the benefit of shareholders. Performance assessment of board members should be fair and appropriate. Investors should review company reports over several years to see if this committee has properly recruited board members who have fairly protected shareholder interests. Investors should also review: • • • Page 98 Criteria for selecting new board members. Composition, background, and expertise of present board members. How do proposed new members complement the existing board? The process for finding new members (i.e., input from outside the firm versus management suggestions). ©2015 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors • • • Attendance records. Succession plans for executive management (if such plans exist). The committee's report, including any actions, decisions, and discussion. Other Board Committees Additional committees can provide more insight into goals and strategies of the firm. These committees are more likely to fall outside typical corporate governance codes, so they are more likely to be comprised of members of executive management. Be wary of this-independence is once again critical to maintain shareowners' best interests. LOS 40.£: Describe provisions that should be included in a strong corporate code of ethics. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 212 A code of ethics for a firm sets the standard for basic principles of integrity, trust, and honesty. It gives the staff behavioral standards and addresses conflicts of interest. Ethical breaches can lead to big problems for firms, resulting in sanctions, fines, management turnover, and unwanted negative publicity. Having an ethical code can be a mitigating factor with regulators if a breach occurs. With respect to board members and persons related to board members, it is important to discourage consultancy contracts, finder's fees for identifying merger or acquisition targets, and other compensation from the company as this can compromise the independence of board members from management. With respect to other corporate personnel and their friends and relations, it is important to discourage related-party transactions as well so that shareholders can be confident that company transactions are to their benefit rather than to the benefit of company insiders. The same holds true for personal use of company assets by board members as well as company management and their families. Personal use of company assets should be discouraged to preserve and promote board member independence and to ensure that company assets are used exclusively to generate value for the company and its shareholders. In the United States and many other countries, investors can get information about either of these practices in the annual report (under related-party transactions), the annual corporate governance report, or in proxy statements. In the case of newly public companies, the prospectus will disclose any stock sales to insiders and related persons that have been recently made at prices less than the offering price, because such transactions will tend to dilute shareholder interests. When analyzing ethics codes, these are items to consider: • • Make sure the board of directors receives relevant corporate information in a timely manner. Ethics codes should be in compliance with the corporate governance laws of the location country and with the governance requirements set forth by the local stock exchange. Firms should disclose whether they adhered to their own ethical code, including any reasons for failure. ©20 15 Kaplan, Inc. Page 99 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors • • • • • The ethical code should prohibit advantages to the firm's ni siders that are not offered to shareowners. A person should be designated to be responsible for corporate governance. If selected management personnel receive waivers from theethics code, reasons should be given. If any provisions of the ethics code were waived recently, ht e firm should explain why. The firm's ethics code should be audited and improved periodically. In evaluating management, investors should: • • • • Verify that the firm has committed to an ethical framework and adopted a code of ethics. See if the firm permits board members or management to use firm assets for personal reasons. Analyze executive compensation to assess whether it is commensurate with responsibilities and performance. Look into the size, purpose, means of financing, and duration of any sharerepurchase programs. LOS 40.g: Evaluate, from a shareowner's perspective, company policies related to voting rules, shareowner sponsored proposals, common stock classes, and takeover defenses. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 219 The ability to vote proxies is a fundamental shareholder right. If the firm makes it difficult to vote proxies, it limits the ability of shareholders to express their views and affect the firm's future direction. Investors should consider whether the firm: • • • • Limits the ability to vote shares by requiring attendance at the annual meeting. Groups its meetings to be held the same day as other companies in the same region and also requires attendance to cast votes. Allows proxy voting by some remote mechanism. Is allowed under its governance code to use share blocking, a mechanism that prevents investors who wish to vote their shares from trading their shares during a period prior to the annual meeting. Confidential Voting Investors should determine if shareholders are able to cast confidential votes. This can encourage unbiased voting. In looking at this issue, investors should consider whether: • • • • Page 100 The firm uses a third party to tabulate votes. The third party or the firm retains voting records. The tabulation is subject to audit. Shareholders are entitled to vote only if present. ©20 15 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors Cumulative Voting Shareholders may be able to cast the cumulative number of votes allotted to their shares for one or a limited number of board nominees. Cumulative voting is generally viewed as favorable for shareholders. However, investors should be cautious in the event the firm has a considerable minority shareholder group, such as a founding family, that can serve its own interests through cumulative voting. Information on possible cumulative voting rights will be contained in the articles of organization and bylaws, the prospectus, or Form 8-A, which must be filed with the Securities and Exchange Commission in the United States. Voting for Other Corporate Changes Changes to corporate structure or policies can change the relationship between shareholders and the firm. Watch for changes to: • • • • • • Articles of organization. Bylaws. Governance structures. Voting rights and procedures. Poison pill provisions (these are impediments to an acquisition of the firm). Provisions for change-in-control. Regarding issues requiring shareholder approval, consider whether shareholders: • • • • • • • Must approve corporate change proposals with supermajority votes. Will be able to vote on the sale of the firm, or part of it, to a ht ird-party buyer. Will be able to vote on major executive compensation issues. Will be able to approve any anti-takeover measures. Will be able to periodically reconsider and re-vote on rules that require supermajority voting to revise any governance documents. Have the ability to vote for changes in articles of organization, bylaws, governance structures, and voting rights and procedures. Have the ability to use their relatively small ownership interest to force a vote on a special interest issue. Investors should also be able to review issues such as: • • • Share buy-back programs that may be used to fund share-based compensation grants. Amendments or other changes to a firm's charter and bylaws. Issuance of new capital stock. Shareowner-Sponsored Board Nominations Investors need to determine whether the firm's shareholders have the power to put forth an independent board nominee. Having such flexibility is positive for investors as it allows them to address their concerns and protect their interests through direct board representation. Additional items to consider: • Under what circumstances can a shareholder nominate a board member? ©20 15 Kaplan, Inc. Page 101 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors • • Can shareowners vote to remove a board member? How does the firm handle contested board elections? The proxy statement is a good source document for information about these issues in the United States. In many jurisdictions, articles of organization and corporate bylaws are other good sources of information on shareholder rights. Shareowner-Sponsored Resolutions The right to propose initiatives for consideration at the annual meeting is an important shareholder method to send a message to management. Investors should look at whether: • • • The firm requires a simple majority or a supermajority vote to pass a resolution. Shareholders can hold a special meeting to vote on a specialinitiative. Shareholder-proposed initiatives will benefit all shareholders rather than just a small group. Advisory or Binding Shareowner Proposals Investors should find out if the board and management are required to actually implement any shareholder-approved proposals. Investors should determine whether: • • • The firm has implemented or ignored such proposals in the past. The firm requires a supermajority of votes to approve changes to its bylaws and articles of organization. Any regulatory agencies have pressured firms to act on the et rms of any approved shareholder initiatives. Different Classes of Common Equity Different classes of common equity within a firm may separate the voting rights of those shares from their economic value. Firms with dual classes of common equity could encourage prospective acquirers to only deal directly with shareholders holding the supermajority rights. Firms that separate voting rights from economic rights have historically had more trouble raising equity capital for fixed investment and product development than firms that combine those rights. When looking at a firm's ownership structure, examine whether: • • Page 102 Safeguards in the bylaws and articles of organization protect shareholders who have inferior voting rights. The firm was recently privatized by a government entity and the selling entity retained voting rights. This may prevent shareholders from receiving full value for their shares. ©2015 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors • Any super-voting rights kept by certain classes of shareholders impair the firm's ability to raise equity capital. If a firm has to turn to debt financing, the increase in leverage can harm the firm. Information on these issues can be found in the proxy, Web site, prospectus, or notes to the financial statements. Shareowner Legal Rights Examine whether the investor has the legal right under the corporate governance code and other legal statutes of the jurisdiction in which the firm is headquartered to seek legal redress or regulatory action to enforce and protect shareholder rights. Investors should determine whether: • • • • Legal statutes allow shareholders to take legal actions toenforce ownership rights. The local market regulator, in similar situations, has taken action to enforce shareholder rights. Shareholders are allowed to take legal or regulatory action against the firm's management or board in the case of fraud. Shareholders have "dissenters' rights," which require the firm to repurchase their shares at fair market value in the event of a problem. Takeover Defenses Takeover defenses are provisions that are designed to make a company less attractive to a hostile bidder. Examples of takeover defenses include golden parachutes (rich severance packages for top managers who lose their jobs as a result of a takeover), poison pills (provisions that grant rights to existing shareholders in the event a certain percentage of a company's shares are acquired), and greenmail (use of corporate funds to buy back the shares of a hostile acquirer at a premium to their market value). All of these defenses may be used to counter a hostile bid, and their probable effect is to decrease share value. When reviewing the firm's takeover defenses, investors should: • • • • Ask whether the firm requires shareholder approval to implement such takeover measures. Ask whether the firm has received any acquisition interest in the past. Consider that the firm may use its cash to "payoff" a hostile bidder. Shareholders should take steps to discourage this activity. Consider whether any change of control issues would invoke the interest of a national or local government and, as a result, pressure the seller to change the terms of the acquisition or merger. ©20 15 Kaplan, Inc. Page 103 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors LOS 40.a Corporate governance is the set of internal controls, processes, and procedures by which firms are managed. Good corporate governance practices ensure that the board of directors is independent of management and that the firm and its managers act lawfully, ethically, and in the interests of shareholders. LOS 40.b A majority of board and committee members should be independent (not management), and the board should meet regularly without management present. Board members should have the experience and knowledge necessary to advise management and review its activities. The board should have the resources it needs to act independently, including the ability to hire outside consultants without approval from management. LOS 40.c A board can be considered independent if its decisions are not controlled or biased by the management of the firm. An independent board member must work to protect the long-term interests of shareholders. LOS 40.d Board members should have the skills and experience required to make informed decisions about the firm's future. A qualified board member should have experience with: • The products or services the firm produces. • Financial operations, accounting, and auditing. • Legal issues. • Strategies and planning. • The firm's business and financial risks. Members who serve on the board for a long time (more than ten years) may become too closely aligned with management to be considered independent. Page 104 ©2015 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors LOS 40.e The audit committee is responsible for providing financial information to shareholders. The audit committee should: • Follow proper accounting and auditing procedures. • Appoint an external auditor that is free from management influence. • Resolve conflicts between the auditor and management in a way that favors shareholders. • Approve or reject any non-audit engagements with the external auditor. • Have no restrictions on its communications with the firm'sinternal auditors. • Control the audit budget. The compensation (remuneration) committee sets the compensation for the firm's executives. The compensation committee should: • Determine whether executives' compensation is appropriate and linked to the firm's long-term profitability. • Provide shareholders with details about executive compensation in public documents. • Require the firm and the board to seek shareholder approval for any share-based compensation plans. The nominations committee is responsible for recruiting new, qualified, independent board members. The nominations committee should: • Review the performance, independence, and skills of existing board members. • Create nomination procedures and policies. • Prepare a succession plan for senior management. LOS 40.f A firm's code of ethics sets the standard for basic principles of integrity, trust, and honesty. Having a code of ethics can be a mitigating factor with regulators if a breach occurs. A strong code of ethics should: • Comply with corporate governance standards of the company's home country and stock exchange. • Prohibit the company from giving advantages to company insiders that are not available to shareholders. • Discourage payments to board members of consultancy fees or finder's fees for • • • acquIsItIon targets. • Designate a person responsible for corporate governance. A company with a weak code of ethics may allow practices such as transactions with parties related to management or personal use of company assets by management or board members. Such practices benefit company insiders rather than shareholders. ©20 15 Kaplan, Inc. Page 105 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors LOS 40.g Consider whether company policies make it difficult to vote proxies and whether a significant minority shareholder group can serve their own interests through cumulative voting. Confidential voting and remote proxy voting promote the interests of shareholders. Investors should determine whether a firm permits shareholders to nominate board members and propose initiatives to be discussed at the annual meeting and whether the firm regards shareholder proposals as binding or advisory. Corporate structure changes can alter the relationship between shareholders and the firm. Different classes of equity may separate the voting rights of shares from their economic value. Takeover defenses are provisions that make a company less attractive to a hostile bidder or more difficult to acquire. They are generally not in shareholders' interests. Page 106 ©20l5 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors 1. Which of the following board characteristics would least likely be an indication of high-quality corporate governance? A. Board members have staggered terms. B. The board can hire independent consultants. C. The board has a separate committee to set executive pay. 2. Which of the following board members would most likely be considered well chosen based on the principles of good corporate governance? A. A board member of Company B who is also the CEO of Company B. B. A board member of Company B who is a partner in an accounting firm that competes with the firm's auditor. C. A board member of Company A who is president of Company B, when the CFO of Company A sits on Company B's board. 3. Which of the following is least likely to enable a corporate board to exercise its duty by acting in the long-term interest of shareholders? A. The board meets regularly outside the presence of management. B. A majority of the board members are independent of firm management. C. The board has representatives from key suppliers and important customers. 4. Which of the following would most likely be considered a negative factor in assessing the suitability of a board member? The board member: A. has served for ten years. B. has served on other boards. C. is a former CEO of another firm. 5. Which of the following would least likely be an indication of poor corporate governance? A. A board member leases office space to the company in a building he owns. B. There are board members who do not have previous experience in the industry in which the firm operates. C. A board member has a consulting contract with the firm to provide strategic vision for the technology research and development effort. 6. Which of the following would most likely be considered a poor corporate practice in terms of promoting shareholder interests? A. The firm can use "share blocking." B. The firm uses a third party to tabulate shareholder votes. C. Voting for board members does not allow cumulative voting by shareholders of all votes allotted to their shares. ytsomlkiea ©20 15 Kaplan, Inc. Page 107 Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors 7. Page 108 Two analysts are discussing shareholder defenses against hostile takeovers. Alice states, "It is positive for shareholders that the board has shown a willingness to buy back shares from holders who may be in a position to effect a hostile takeover of the firm at less than its long-term value to shareholders." Bradley states, "Firms that are likely takeover targets should offer valuable exit packages in the event of a hostile takeover because they are necessary to recruit highly talented top executives, such as the CEO." From the perspective of good corporate governance, are these statements correct? A. Both statements are correct. B. Neither statement is correct. C. Only one of the statements is correct. ©2015 Kaplan, Inc. Study Session 11 Cross- Reference to CFA Institute Assigned Reading #40 - The Corporate Governance of Listed Companies: A Manual for Investors 1. A Staggered terms make it more difficult for shareholders to change the board of directors. Annual elections of all members make the board more responsive to shareholder wishes. 2. B A board member who is a partner in an unrelated accounting firm would be considered independent, has no particular relation to firm management, and could be a valuable addition to the board. 3. C Board members should not be closely aligned with a firm's suppliers or customers because they may act in the interest of suppliers and customers rather than in the interest of shareholders. 4. A While experience may be a good thing, a board member with long tenure may be too closely aligned with management to be considered an independent member. 5. B Lack of previous experience in the firm's industry is not necessarily a negative and can be consistent with an independent board member who acts in shareholders' long-term interests. Examples might be board members with specialized knowledge of finance, marketing, management, accounting, or auditing. The other answers indicate possible conflicts of interest. 6. A Share blocking prevents shareholders from trading their shares over a period prior to the annual meeting and is considered a restriction on the ability of shareholders to express their opinions and act in their own interests. Cumulative voting can allow a minority group, such as a founding family, to serve its own interests. Third party tabulation of shareowner votes is considered a good corporate governance practice. 7. B Defenses against hostile takeovers such as greenmail (Alice) or golden parachutes (Bradley) tend to protect entrenched or poorly performing managements and typically decrease share values. Shareholders as a group always have the choice not to sell when a takeover offer is not in their long-term interests. ©20 15 Kaplan, Inc. Page 109 8 questions: 12 minutes utsqonmie 1. nA yxwvutsrqponmlkjihgfedcbaWTSRPKIFEDCBA An analyst calculates the following leverage ratios for Burkhardt Company and Dutchin Company: yvtsrponmlkigfecaOLFD Degree of Operating Leverage Degree of Financial Leverage Burkhardt 1.6 3.0 Dutchin 1.2 4.0 If both companies' sales increase by 50/0, what are the most likely effects on the companies' earnings before interest and taxes (EBIT) and earnings per share (EPS)? A. Both companies' EBIT will increase by the same percentage. B. Dutchin's EPS will increase by a larger percentage than Burkhardt's EPS. C. Burkhardt's EBIT will increase by a larger percentage than Dutchin's EBIT. 2. Which of the following would most likely lead to an increase in a typical firm's capital investment for the current period? A. A need to increase inventory. B. An increase in the firm's expected marginal tax rate. C. A decrease in the market value of the firm's debt. 3. Which of the following changes in a firm's working capital management is most likely to result in a shorter operating cycle? A. Reducing stock-outs by carrying greater quantities of inventory. B. Stretching its payables by paying on the last permitted date. C. Changing its credit terms for customers from 2/10, net 60 to 2/10, net 30. 4. A company's operations analyst is evaluating a plant expansion project that is likely to be financed in part by issuing new common equity. Flotation costs are expected to be 40/0 of the amount of new equity capital raised. The most appropriate way for the analyst to treat the flotation costs is to: A. ignore them, because flotation costs for common equity are likely to be nonmaterial. B. estimate the cost of equity capital based on a share price 40/0 less than the • current prIce. C. determine the flotation cost attributable to this project and treat it as part of the project's initial cash outflow. 5. Page 110 A board of directors is most likely to act in the long-term interest of shareholders if: A. all board members are elected annually. B. most board members are selected from outside the company's industry. C. there are board members who represent the company's key supplier and largest customer. ©2015 Kaplan, Inc. Self-Test: Corporate Finance 6. The manufacturer of Pow Detergent has developed New Improved Pow with Dirteaters and is considering adding it to its product line. New Improved Pow would sell at a premium price compared to Pow. In order to manufacture New Improved Pow, the firm will need to build a new facility and purchase new equipment. Which of the following is least likely included when calculating the appropriate cash flows for analysis of whether to add New Improved Pow to its product line? A. Expected depreciation on the new facility and equipment for tax purposes. B. Costs of a marketing survey performed last month to decide whether to introduce New Improved Pow. C. Reduced sales of Pow that result from the introduction of New Improved Pow. ytsomlkiea 7. The use of secondary sources of liquidity would most likely be considered: A. a normal part of daily business for a company. B. a signal that a company's financial position is deteriorating. C. a lower-cost source of short-term financing compared to primary sources of liquidity. 8. A firm's debt-to-equity ratio is most likely to increase as a result of a(n): A. extra dividend. B. stock dividend. C. purchase of a machine for cash. ©20 15 Kaplan, Inc. Page 111 Self-Test: Corporate Finance Page 112 1. C The DOL is the percent change in operating income (EBIT) that will result from a 1% change in sales. Because Burkhardt has a higher DOL than Dutchin, Burkhardt's EBIT will increase by a larger percentage if both companies' sales increase by the same percentage. The percentage change in EPS resulting from a change in sales of 1% is measured by the degree of total leverage. The DTL for Burkhardt is 1.6 x 3.0 = 4.8, and the DTL for Dutchin is 1.2 x 4.0 = 4.8. If both companies' sales increase by the same percentage, their EPS will also increase by the same percentage. 2. B Because a typical firm has both equity and debt financing, an increase in the firm's tax rate will decrease the after-tax cost of debt and consequently decrease the firm's WACC, which can change a project's NPV from negative to positive. A decrease in the market value of the firm's debt will increase the market yield on the debt, which will increase the after-tax cost of debt and the firm's WACC. Increases in inventory increase current assets and working capital needs, not capital investment. 3. C The operating cycle is average days of receivables plus average days of inventory. Changing its credit terms for customers from "net 60" to "net 30" would likely decrease the firm's average days of receivables and shorten its operating cycle. Increasing inventory quantities would increase average days of inventory and lengthen the operating cycle. Stretching payables by waiting until their due date to pay would increase the firm's average days of payables. This would shorten the firm's cash conversion cycle (days of receivables + days of inventory - days of payables) but would not affect its operating cycle. 4. C The correct treatment of flotation costs is to treat them as a cash outflow at the project's initiation. Methods that adjust the cost of equity capital (and therefore the WACC) for flotation costs are incorrect because the cost of capital is an ongoing expense, whereas flotation costs are actually a one-time expense. Flotation costs for common equity are typically large enough that they must be considered in computing a project's NPV. 5. A Annual elections of all board members (as compared to longer terms) make a board more likely to represent shareholders' long-term interests because it is easier for shareholders to nominate and elect new members. Board members who do not have direct experience in the company's industry might lack the specific knowledge they need to give proper oversight to management's decisions and, therefore, tend to defer to management. Board members who are aligned with the company's customers and suppliers might have interests that conflict with shareholders' interests. 6. B Costs that are incurred prior to the decision of whether or not to pursue a project are sunk costs and should not be used in the NPV calculation. Only cash flows that result from the decision to actually do the project should be considered in the analysis. Taxes must be deducted so the project's cash flows can be analyzed on an after-tax basis. Because depreciation is tax deductible, expected depreciation will affect annual taxes and after-tax cash flows. Cannibalization of sales of an existing product is an externality that should be included in the estimation of incremental project cash flows. ©2015 Kaplan, Inc. Self-Test: Corporate Finance 7. B Secondary sources of liquidity include renegotiating debt contracts, liquidating assets, and filing for bankruptcy protection and reorganization. The use of these sources of funds is typically a signal that a company's financial position is deteriorating. The liquidity provided by these sources usually comes at a substantially higher cost than liquidity provided by primary sources. 8. A An extra dividend is a cash payment to shareholders that will decrease assets (cash) and shareholders' equity (retained earnings) but will not affect liabilities. Unchanged debt and lower equity increase the debt-to-equity ratio. Stock splits, reverse stock splits, and stock dividends change the number of shares outstanding but do not change the value of shareholders' equity or require any use of the firm's assets. Purchasing a machine for cash exchanges one asset for another asset and does not affect total assets, debt, or equity. ©20 15 Kaplan, Inc. Page 113 The following is a review of the Portfolio Management principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #41.TRPONMLIGFEA PORTFOLIO MANAGEMENT: AN OVERVIEW usocXWVRONMIFEA Study Session 12 EXAM Focus Here, we introduce the portfolio management process and the investment policy statement. In this topic review, you will learn the investment needs of different types of investors, as well as the different kinds of pooled investments. Later, our topic review of "Basics of Portfolio Planning and Construction" will provide more detail on investment policy statements and investor objectives and constraints. LOS 41.a: Describe the portfolio approach to investing. urponmligecaVPFCA CFA® Program Curriculum, Volume 4, page 235 The portfolio perspective refers to evaluating individual investments by their contribution to the risk and return of an investor's portfolio. The alternative to taking a portfolio perspective is to examine the risk and return of individual investments in isolation. An investor who holds all his wealth in a single stock because he believes it to be the best stock available is not taking the portfolio perspective-his portfolio is very risky compared to holding a diversified portfolio of stocks. Modern portfolio theory concludes that the extra risk from holding only a single security is not rewarded with higher expected investment returns. Conversely, diversification allows an investor to reduce portfolio risk without necessarily reducing the portfolio's expected return. In the early 1950s, the research of Professor Harry Markowitz provided a framework for measuring the risk-reduction benefits of diversification. Using the standard deviation of returns as the measure of investment risk, he investigated how combining risky securities into a portfolio affected the portfolio's risk and expected return. One important conclusion of his model is that unless the returns of the risky assets are perfectly positively correlated, risk is reduced by diversifying across assets. In the 1960s, professors Treynor, Sharpe, Mossin, and Lintner independently extended this work into what has become known as modern portfolio theory (MPT). MPT results in equilibrium expected returns for securities and portfolios that are a linear function of each security's or portfolio's market risk (the risk that cannot be reduced by diversification) . One measure of the benefits of diversification is the diversification ratio. It is calculated as the ratio of the risk of an equally weighted portfolio of n securities (measured by its standard deviation of returns) to the risk of a single security selected at random from the n securities. Note that the expected return of an equal-weighted portfolio is also the expected return from selecting one of the n portfolio securities at random (the simple n Page 114 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #41 - Portfolio Management:nA An Overview average of expected security returns in both instances). If the average standard deviation of returns for the n stocks is 250/0, and the standard deviation of returns for an equally weighted portfolio of the n stocks is 180/0, the diversification ratio is 18/25 = 0.72. urponmligecaVPCA n While the diversification ratio provides a quick measure of the potential benefits of diversification, an equal-weighted portfolio is not necessarily the portfolio that provides the greatest reduction in risk. Computer optimization can calculate the portfolio weights that will produce the lowest portfolio risk (standard deviation of returns) for a given group of securities. Portfolio diversification works best when financial markets are operating normally; diversification provides less reduction of risk during market turmoil, such as the credit contagion of 2008. During periods of financial crisis, correlations tend to increase, which reduces the benefits of diversification. LOS 41. b: Describe types of investors and distinctive characteristics and needs of each. CPA ® Program Curriculum, Volume 4, page 244 Individual investors save and invest for a variety of reasons, including purchasing a house or educating their children. In many countries, special accounts allow citizens to invest for retirement and to defer any taxes on investment income and gains until the funds are withdrawn. Defined contribution pension plans are popular vehicles for these investments. Pension plans are described later in this topic review. Many types of institutions have large investment portfolios. An endowment is a fund that is dedicated to providing financial support on an ongoing basis for a specific purpose. For example, in the United States, many universities have large endowment funds to support their programs. A foundation is a fund established for charitable purposes to support specific types of activities or to fund research related to a particular disease. A typical foundation's investment objective is to fund the activity or research on a continuing basis without decreasing the real (inflation adjusted) value of the portfolio assets. Foundations and endowments typically have long investment horizons, high risk tolerance, and, aside from their planned spending needs, little need for additional liquidity. The investment objective of a bank, simply put, is to earn more on the bank's loans and investments than the bank pays for deposits of various types. Banks seek to keep risk low and need adequate liquidity to meet investor withdrawals as they occur. Insurance companies invest customer premiums with the objective of funding customer claims as they occur. Life insurance companies have a relatively long-term investment horizon, while property and casualty (P&C) insurers have a shorter investment horizon because claims are expected to arise sooner than for life insurers. ©20 15 Kaplan, Inc. Page 115 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #41 - Portfolio Management: An Overview Investment companies manage the pooled funds of many investors. Mutual funds manage these pooled funds in particular styles (e.g., index investing, growth investing, bond investing) and restrict their investments to particular subcategories of investments (e.g., large-firm stocks, energy stocks, speculative bonds) or particular regions (emerging market stocks, international bonds, Asian-firm stocks). Sovereign wealth funds refer to pools of assets owned by a government. For example, the Abu Dhabi Investment Authority, a sovereign wealth fund in the United Arab Emirates funded by Abu Dhabi government surpluses, has an estimated US$627 billion in assets. 1 Figure 1 provides a summary of the risk tolerance, investment horizon, liquidity needs, and income objectives for different types of investors. Figure 1: Characteristics Investor of Different Types of InvestorszywvutsrqponmlkigfedcaVTRPNLIHCA Risk Tolerance Investment Horizon Liquidity Needs Income Needs Depends on individual Depends on individual Depends on individual Depends on individual Banks Low Short High Pay interest Endowments High Long Low Spending level High Low Individuals Insurance Mu tual funds Defined benefit • penslons Low Long-life Short-P&C Depends on fund Depends on fund High Depends on fund High Long Low Depends on age LOS 41.c: Describe defined contribution and defined benefit pension plans. CPA ® Program Curriculum, Volume 4, page 244 A defined contribution pension plan is a retirement plan in which the firm contributes a sum each period to the employee's retirement account. The firm's contribution can be based on any number of factors, including years of service, the employee's age, compensation, profitability, or even a percentage of the employee's contribution. In any event, the firm makes no promise to the employee regarding the future value of the plan assets. The investment decisions are left to the employee, who assumes all of the investment risk. In a defined benefit pension plan, the firm promises to make periodic payments to employees after retirement. The benefit is usually based on the employee's years of service and the employee's compensation at, or near, retirement. For example, an employee might earn a retirement benefit of 20/0 of her final salary for each year of service. Consequently, an employee with 20 years of service and a final salary of $100,000, would receive $40,000 ($100,000 final salary x 20/0 x 20 years of service) each year upon retirement until death. Because the employee's future benefit is defined, the employer assumes the investment risk. The employer makes contributions to a fund 1. Source: SWF Institute (www.swfinstitute.orglfund-rankings). Page 116 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #41 - Portfolio Management:nA An Overview established to provide the promised future benefits. Poor investment performance will increase the amount of required employer contributions to the fund. LOS 41.d: Describe the steps in the portfolio management process. wutrponmligedcbaVSPFCA CFA® Program Curriculum, Volume 4, page 250 There are three major steps in the portfolio management process: Step 1: The planning step begins with an analysis of the investor's risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, income needs, and any unique circumstances or investor preferences. This analysis results in an investment policy statement (IPS) that details the investor's investment objectives and constraints. It should also specify an objective benchmark (such as an index return) against which the success of the portfolio management process will be measured. The IPS should be updated at least every few years and any time the investor's objectives or constraints change significantly. Step 2: The execution step involves an analysis of the risk and return characteristics of various asset classes to determine how funds will be allocated to the various asset types. Often, in what is referred to as a top-down analysis, a portfolio manager will examine current economic conditions and forecasts of such macroeconomic variables as GDP growth, inflation, and interest rates, in order to identify the asset classes that are most attractive. The resulting portfolio is typically diversified across such asset classes as cash, fixed-income securities, publicly traded equities, hedge funds, private equity, and real estate, as well as commodities and other real assets. Once the asset class allocations are determined, portfolio managers may attempt to identify the most attractive securities within the asset class. Security analysts use model valuations for securities to identify those that appear undervalued in what is termed bottom-up security analysis. Step 3: The feedback step is the final step. Over time, investor circumstances will change, risk and return characteristics of asset classes will change, and the actual weights of the assets in the portfolio will change with asset prices. The portfolio manager must monitor these changes and rebalance the portfolio periodically in response, adjusting the allocations to the various asset classes back to their desired percentages. The manager must also measure portfolio performance and evaluate it relative to the return on the benchmark portfolio identified in the IPS. LOS 41.e: Describe mutual funds and compare them with other pooled investment products. CFA ® Program Curriculum, Volume 4, page 254 Mutual funds are one form of pooled investments (i.e., a single portfolio that contains investment funds from multiple investors). Each investor owns shares representing ©20 15 Kaplan, Inc. Page 117 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #41 - Portfolio Management: An Overview ownership of a portion of the overall portfolio. The total net value of the assets in the fund (pool) divided by the number of such shares issued is referred to as the net asset value (NAV) of each share. With an open-end fund, investors can buy newly issued shares at the NAV. Newly invested cash is invested by the mutual fund managers in additional portfolio securities. Investors can redeem their shares (sell them back to the fund) at NAVas well. All mutual funds charge a fee for the ongoing management of the portfolio assets, which is expressed as a percentage of the net asset value of the fund. No-load funds do not charge additional fees for purchasing shares (up-front fees) or for redeeming shares (redemption fees). Load funds charge either up-front fees, redemption fees, or both. Closed-end funds are professionally managed pools of investor money that do not take new investments into the fund or redeem investor shares. The shares of a closed-end fund trade like equity shares (on exchanges or over-the-counter). As with open-end funds, the portfolio management firm charges ongoing management fees. Types of Mutual Funds Money market funds invest in short-term debt securities and provide interest income with very low risk of changes in share value. Fund NAVs are typically set to one currency unit, but there have been instances over recent years in which the NAV of some funds declined when the securities they held dropped dramatically in value. Funds are differentiated by the types of money market securities they purchase and their average • • matuntres. Bond mutual funds invest in fixed-income securities. They are differentiated by bond maturities, credit ratings, issuers, and types. Examples include government bond funds, tax-exempt bond funds, high-yield (lower rated corporate) bond funds, and global bond funds. A great variety of stock mutual funds are available to investors. Index funds are passively managed; that is, the portfolio is constructed to match the performance of a particular index, such as the Standard & Poor's 500 Index. Actively managed funds refer to funds where the management selects individual securities with the goal of producing returns greater than those of their benchmark indexes. Annual management fees are higher for actively managed funds, and actively managed funds have higher turnover of portfolio securities (the percentage of investments that are changed during the year). This leads to greater tax liabilities compared to passively managed index funds. Other Forms of Pooled Investments Exchange-traded funds (ETFs) are similar to closed-end funds in that purchases and sales are made in the market rather than with the fund itself. There are important differences, however. While closed-end funds are often actively managed, ETFs are most often invested to match a particular index (passively managed). With closed-end funds, the market price of shares can differ significantly from their NAV due to imbalances Page 118 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #41 - Portfolio Management:nA An Overview between investor supply and demand for shares at any point in time. Special redemption provisions for ETFs are designed to keep their market prices very close to their NAVs. ETFs can be sold short, purchased on margin, and traded at intraday prices, whereas open-end funds are typically sold and redeemed only daily, based on the share NAV calculated with closing asset prices. Investors in ETFs must pay brokerage commissions when they trade, and there is a spread between the bid price at which market makers will buy shares and the ask price at which market makers will sell shares. With most ETFs, investors receive any dividend income on portfolio stocks in cash, while openend funds offer the alternative of reinvesting dividends in additional fund shares. One final difference is that ETFs may produce less capital gains liability compared to openend index funds. This is because investor sales of ETF shares do not require the fund to sell any securities. If an open-end fund has significant redemptions that cause it to sell appreciated portfolio shares, shareholders incur a capital gains tax liability. A separately managed account is a portfolio that is owned by a single investor and managed according to that investor's needs and preferences. No shares are issued, as the single investor owns the entire account. Hedge funds are pools of investor funds that are not regulated to the extent that mutual funds are. Hedge funds are limited in the number of investors who can invest in the fund and are often sold only to qualified investors who have a minimum amount of overall portfolio wealth. Minimum investments can be quite high, often between $250,000 and $1 million. There is a great variety of hedge fund strategies, and major hedge fund categories are based on the investment strategy that the funds pursue: • • • • • • • Long/short funds buy securities that are expected to outperform the overall market and sell securities short that are expected to underperform the overall market. Equity market-neutral funds are long/short funds with long stock positions that are just offset in value by stocks sold short. These funds are designed to be neutral with respect to overall market movements so that they can be profitable in both up and down markets as long as their longs outperform their shorts. Anequity hedge fund with a bias is a long/short fund dedicated to a larger long position relative to short sales (a long bias) or to a greater short position relative to long positions (a short bias). Event-driven funds invest in response to one-time corporate events, such as mergers and acquisitions. Fixed-income arbitrage funds take long and short positions in debt securities, attempting to profit from minor mispricings while minimizing the effects of interest rate changes on portfolio values. Convertible bond arbitrage funds take long and short positions in convertible bonds and the equity shares they can be converted into in order to profit from a relative mispricing between the two. Global macro funds speculate on changes in international ni terest rates and currency exchange rates, often using derivative securities and a great amount of leverage. Buyout funds (private equity funds) typically buy entire public companies and take them private (their shares no longer trade). The purchase of the companies is often funded with a significant increase in the firm's debt (a leveraged buyout). The fund ©20 15 Kaplan, Inc. Page 119 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #41 - Portfolio Management: An Overview attempts to reorganize the firm to increase its cash flow, pay down its debt, increase the value of its equity, and then sell the restructured firm or its parts in a public offering or to another company over a fairly short time horizon of three to five years. Venture capital funds typically invest in companies in their start-up phase, with the intent to grow them into valuable companies that can be sold publicly via an IPO or sold to an established firm. Both buyout funds and venture capital funds are very involved in the management of their portfolio companies and often have expertise in the industries on which they focus. Page 120 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #41 - Portfolio Management:nA An Overview LOS 41.a A diversified portfolio produces reduced risk for a given level of expected return, compared to investing in an individual security. Modern portfolio theory concludes that investors that do not take a portfolio perspective bear risk that is not rewarded with greater expected return. LOS 41.h Types of investment management clients and their characteristics: zyvutsrqponmlkiedcaTRNLIH Investor Type Risk Tolerance Investment Horizon Liquidity Needs Income Needs Depends on individual Depends on individual Depends on individual Depends on individual Banks Low Short High Pay interest Endowments High Long Low Spending level Insurance Low High Low Individuals Mutual funds Defined benefit • penSIon Long-life Short-P&C Depends on fund Depends on fund High Depends on fund High Long Low Depends on age LOS 41.c In a defined contribution plan, the employer contributes a certain sum each period to the employee's retirement account. The employer makes no promise regarding the future value of the plan assets; thus, the employee assumes all of the investment risk. In a defined benefit plan, the employer promises to make periodic payments to the employee after retirement. Because the employee's future benefit is defined, the employer assumes the investment risk. ©20 15 Kaplan, Inc. Page 121 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #41 - Portfolio Management: An Overview LOS 41.d The three steps in the portfolio management process are: 1. Planning: Determine client needs and circumstances, including the client's return objectives, risk tolerance, constraints, and preferences. Create, and then periodically review and update, an investment policy statement (IPS) that spells out these needs and circumstances. 2. Execution: Construct the client portfolio by determining suitable allocations to various asset classes based on the IPS and on expectations about macroeconomic variables such as inflation, interest rates, and GDP growth (top-down analysis). Identify attractively priced securities within an asset class for client portfolios based on valuation estimates from security analysts (bottom-up analysis). 3. Feedback: Monitor and rebalance the portfolio to adjust asset class allocations and securities holdings in response to market performance. Measure and report performance relative to the performance benchmark specified in the IPS. LOS 41.e Mutual funds combine funds from many investors into a single portfolio that is invested in a specified class of securities or to match a specific index. Many varieties exist, including money market funds, bond funds, stock funds, and balanced (hybrid) funds. Open-ended shares can be bought or sold at the net asset value. Closed-ended funds have a fixed number of shares that trade at a price determined by the market. Exchange-traded funds are similar to mutual funds, but investors can buy and sell ETF shares in the same way as shares of stock. Management fees are generally low, though trading ETFs results in brokerage costs. Separately managed accounts are portfolios managed for individual investors who have substantial assets. In return for an annual fee based on assets, the investor receives personalized investment advice. Hedge funds are available only to accredited investors and are exempt from most reporting requirements. Many different hedge fund strategies exist. A typical annual fee structure is 200/0 of excess performance plus 20/0 of assets under management. Buyout funds involve taking a company private by buying all available shares, usually funded by issuing debt. The company is then restructured to increase cash flow. Investors typically exit the investment within three to five years. Venture capital funds are similar to buyout funds, except that the companies purchased are in the start-up phase. Venture capital funds, like buyout funds, also provide advice and expertise to the start-ups. Page 122 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #41 - Portfolio Management:ncA An Overview 1. Compared to investing in a single security, diversification provides investors a way to: A. increase the expected rate of return. B. decrease the volatility of returns. C. increase the probability of high returns. 2. Portfolio diversification is least likely to protect against losses: A. during severe market turmoil. B. when markets are operating normally. c. when the portfolio securities have low return correlation. 3. In a defined contribution pension plan: A. the employee accepts the investment risk. B. the plan sponsor promises a predetermined retirement income to • • partIcIpants. C. the plan manager attempts to match the fund's assets to its liabilities. 4. In A. B. C. 5. Low risk tolerance and high liquidity requirements best describe the typical investment needs of a(n): A. defined-benefit pension plan. B. foundation. C. insurance company. 6. A long time horizon and low liquidity requirements best describe the investment needs of a(n): A. endowment. B. insurance company. C. bank. 7. Which of the following is least likely to be considered an appropriate schedule for reviewing and updating an investment policy statement? A. At regular intervals (e.g., every year). B. When there is a major change in the client's constraints. C. Frequently, based on the recent performance of the portfolio. 8. A top-down security analysis begins by: A. analyzing a firm's business prospects and quality of management. B. identifying the most attractive companies within each industry. C. examining economic conditions. ytslkieba a defined benefit pension plan: the employee assumes the investment risk. the employer contributes to the employee's retirement account each period. the plan sponsor promises a predetermined retirement income to • • partIcIpants. ©20 15 Kaplan, Inc. Page 123 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #41 - Portfolio Management: An Overview Page 124 9. Compared to exchange-traded funds (ETFs), open-end mutual funds are typically associated with lower: A. brokerage costs. B. minimum investment amounts. C. management fees. 10. Both buyout funds and venture capital funds: A. expect that only a small percentage of investments will payoff. B. play an active role in the management of companies. C. restructure companies to increase cash flow. 11. Hedge funds most likely: A. have stricter reporting requirements than a typical investment firm because of their use of leverage and derivatives. B. hold equal values of long and short securities. C. are not offered for sale to the general public. ytsomlkie ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #41 - Portfolio Management:nA An Overview 1. B Diversification provides an investor reduced risk. However, the expected return is generally similar or less than that expected from investing in a single risky security. Very high or very low returns become less likely. 2. A Portfolio diversification has been shown to be relatively ineffective during severe market turmoil. Portfolio diversification is most effective when the securities have low correlation and the markets are operating normally. 3. A In a defined contribution pension plan, the employee accepts the investment risk. The plan sponsor and manager neither promise a specific level of retirement income to participants nor make investment decisions. These are features of a defined benefit plan. 4. C In a defined benefit plan, the employer promises a specific level of benefits to employees when they retire. Thus, the employer bears the investment risk. 5. C Insurance companies need to be able to pay claims as they arise, which leads to insurance firms having low risk tolerance and high liquidity needs. Defined benefit pension plans and foundations both typically have high risk tolerance and low liquidity needs. 6. A An endowment has a long time horizon and low liquidity needs, as an endowment generally intends to fund its causes perpetually. Both insurance companies and banks require high liquidity. 7. C An IPS should be updated at regular intervals and whenever there is a major change in the client's objectives or constraints. Updating an IPS based on portfolio performance is not recommended. 8. C A top-down analysis begins with an analysis of broad economic trends. After an industry that is expected to perform well is chosen, the most attractive companies within that industry are identified. A bottom-up analysis begins with criteria such as firms' business prospects and quality of management. 9. A Open-end mutual funds do not have brokerage costs, as the shares are purchased from and redeemed with the fund company. Minimum investment amounts and management fees are typically higher for mutual funds. 10. B Both buyout funds and venture capital funds play an active role in the management of companies. Unlike venture capital funds, buyout funds expect that the majority of investments will payoff. Venture capital funds do not typically restructure companies. 11. C Hedge funds may not be offered for sale to the general public; they can be sold only to qualified investors who meet certain criteria. Hedge funds that hold equal values of long and short securities today make up only a small percentage of funds; many other kinds of hedge funds exist that make no attempt to be market neutral. Hedge funds have reporting requirements that are less strict than those of a typical investment firm. ©20 15 Kaplan, Inc. Page 125 The following is a review of the Portfolio Management principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #42.UTSRONMKIGEDCA RISK MANAGEMENT: AN INTRODUCTION Study Session 12XMEA EXAM Focus Here we present a framework for risk management that is broad enough to be applied to corporations in general, financial firms, and individuals, as well as to the management of securities portfolios in any context. The main idea is that organizations should estimate the various risks they face and then reduce some risks and accept or increase other risks. The result should be a bundle of risks that simultaneously matches the risk tolerance of the organization and provides the greatest benefits in terms of reaching the organization's goals. Note that risk is not minimized though this process. The concept of risk budgeting, the categorization of types of risks, and the various methods of risk mitigation all offer testable material. LOS 42.a: Define risk management. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 273 The risk management process seeks to 1) identify the risk tolerance of the organization, 2) identify and measure the risks that the organization faces, and 3) modify and monitor these risks. The process does not seek to minimize or eliminate all of these risks. The organization may increase its exposure to risks it decides to take because it is better able to manage and respond to them. The organization may decrease its exposure to risks that it is less well able to manage and respond to by making organizational changes, purchasing insurance, or entering into hedging transactions. Through these choices the firm aligns the risks it takes with its risk tolerances for these various types of risk. Risk (uncertainty) is not something to be avoided by an organization or in an investment portfolio. Returns above the risk-free rate are earned by taking on risk. While returns for any period are not under the control of mangers, the specific risks and overall level of risk the organization takes are under their control. We can think of risk management as determining organizational risks, determining the optimal bundle of risks for the organization, and implementing risk mitigation strategies to achieve that bundle of risks. We describe the principles of risk management here in a framework that can be applied broadly, not only to firms or organizations in general, but also to the management of investment portfolios and financial firms, and even to individuals deciding how much risk and which specific risks they will take. Individuals follow a similar approach, selecting a bundle of risks that is optimal for maximizing their expected utility (rather than returns or profit). Page 126 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management:nA An Introduction LOS 42. b: Describe features of a risk management framework. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 275 An overall risk management framework encompasses several activities, including: • • • • • • • Establishing processes and policies for risk governance. Determining the organization's risk tolerance. Identifying and measuring existing risks. Managing and mitigating risks to achieve the optimal bundle of risks. Monitoring risk exposures over time. Communicating across the organization. Performing strategic risk analysis. This framework is general, but all of these elements should be addressed in any comprehensive risk management framework. Only by understanding the risks the organization faces, and having the processes and procedures in place to effectively manage and monitor these risks, can an organization align its risk exposures to the goals of the organization. LOS 42.c: Define risk governance and describe elements of effective risk governance. CFA® Program Curriculum, Volume 4, page 281 Risk governance refers to senior management's determination of the risk tolerance of the organization, the elements of its optimal risk exposure strategy, and the framework for oversight of the risk management function. Risk governance seeks to manage risk in a way that supports the overall goals of the organization so it can achieve the best business outcome consistent with the organization's overall risk tolerance. Risk governance provides organization-wide guidance on the risks that should be pursued in an efficient manner, risks that should be subject to limits, and risks that should be reduced or avoided. A risk management committee can provide a way for various parts of the organization to bring up issues of risk measurement, integration of risks, and the best ways to mitigate undesirable risks. LOS 42.d: Explain how risk tolerance affects risk management. CFA® Program Curriculum, Volume 4, page 283 Determining an organization's risk tolerance involves setting the overall risk exposure the organization will take by identifying the risks the firm can effectively take and the risks that the organization should reduce or avoid. Some of the factors that determine an organization's risk tolerance are its expertise in its lines of business, its skill at responding to negative outside events, its regulatory environment, and its financial strength and ability to withstand losses. ©20 15 Kaplan, Inc. Page 127 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management: An Introduction When analyzing risk tolerance, management should examine risks that may exist within the organization as well as those that may arise from outside. The various risks the firm is exposed to must each be considered and weighted against the expected benefits of bearing those risks and how these fit the overall goals of the organization. LOS 42.e: Describe risk budgeting and its role in risk governance. urpomligecaVPFCA CFA ® Program Curriculum, Volume 4, page 285 Risk budgeting is the process of allocating firm resources to assets (or investments) by considering their various risk characteristics and how they combine to meet the organization's risk tolerance. The goal is to allocate the overall amount of acceptable risk to the mix of assets or investments that have the greatest expected returns over time. The risk budget may be a single metric, such as portfolio beta, value at risk, portfolio duration, or returns variance. A risk budget may be constructed based on categories of investments, such as domestic equities, domestic debt securities, international equities, and international debt securities. Another way to allocate a risk budget is to identify specific risk factors that comprise the overall risk of the portfolio or organization. In this case, specific risk factors that affect asset classes to varying degrees, such as interest rate risk, equity market risk, and foreign exchange rate risk, are estimated and aggregated to determine whether they match the overall risk tolerance of the organization. LOS 42.f: Identify financial and non-financial sources of risk and describe how they may interact. CFA® Program Curriculum, Volume 4, page 288 Financial risks are those that arise from exposure to financial markets. Examples are: • • • Credit risk. This is the uncertainty about whether the counterparty to a transaction will fulfill its contractual obligations. Liquidity risk. This is the risk of loss when selling an asset at a time when market conditions make the sales price less than the underlying fair value of the asset. Market risk. This is the uncertainty about market prices ofassets (stocks, commodities, and currencies) and interest rates. Non-financial risks arise from the operations of the organization and from sources external to the organization. Examples are: • • • • Page 128 Operational risk. This is the risk that human error or faulty organizational processes will result in losses. Solvency risk. This is the risk that the organization will be unable to continue to operate because it has run out of cash. Regulatory risk. This is the risk that the regulatory environment will change, imposing costs on the firm or restricting its activities. Governmental or political risk (including tax risk). This is the risk that political actions outside a specific regulatory framework, such as increases in tax rates, will impose significant costs on an organization. ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management:nA An Introduction • • • • Legal risk. This is the uncertainty about the organization's exposure to future legal • acnon. Model risk. This is the risk that asset valuations based on ht e organization's analytical models are incorrect. Tail risk. This is the risk that extreme events (those in thetails of the distribution of outcomes) are more likely than the organization's analysis indicates, especially from incorrectly concluding that the distribution of outcomes is normal. Accounting risk. This is the risk that the organization's accounting policies and estimates are judged to be incorrect. For individuals, risks, such as risk of death (mortality risk) prior to providing for their families' future needs and the risk of living longer than anticipated (longevity risk) so that assets run out, are very important in financial planning. Mortality risk is most often addressed with life insurance, and longevity risk can be reduced by purchasing a lifetime annuity. Risk of health care expenses is addressed with health insurance. Although the risks for an individual are in some ways different from those of organizations, the overall approach is the same, choosing which risks to bear (self-insure), which risks to prevent or avoid, and which risks to take in order to maximize the expected outcome in terms of personal utility or satisfaction. The various risks an organization faces are not independent; they interact in many ways. Consider a firm with market risk that it reduces with option contracts. If markets decline significantly, the firm is owed a payment from the firm on the other side of the option trade, so now there is significant counterparty or credit risk. There also may be legal risks if the counterparty seeks to avoid the payment through loopholes in the contract. Credit losses and legal losses may result in greater liquidity risk as positions must be sold. Additional losses from selling in a declining or less liquid market may increase solvency risk because of the negative impact on the firm's cash position. Interactions among risks must be considered because such interactions are many and frequent. They can be especially important during periods of stress in financial markets, when risk management is most important to the health and possibly the survival of the • • organIzatIon. LOS 42.g: Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 298 Measures of risk for specific asset types include standard deviation, beta, and duration. • • Standard deviation is a measure of the volatility of asset prices and interest rates. Standard deviation may not be the appropriate measure of risk for non-normal probability distributions, especially those with negative skew or positive excess kurtosis (fat tails). Beta measures the market risk of equity securities and portfolios of equity securities. This measure considers the risk reduction benefits of diversification and is appropriate for securities held in a well-diversified portfolio, whereas standard deviation is a measure of risk on a stand-alone basis. ©20 15 Kaplan, Inc. Page 129 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management: An Introduction • Duration is a measure of the price sensitivity of debt securities to changes in interest rates. xvutsrponmlihgfedcbaQPNMIF Professor's Note: We describe and calculate standard deviation in Quantitative Methods; duration in Fixed Income; and beta in the current topic area, Portfolio Management. eW Derivatives risks (sometimes referred to as "the Greeks") include: • • • • Delta. This is the sensitivity of derivatives values to theprice of the underlying asset. Gamma. This is the sensitivity of delta to changes in the price of the underlying asset. Vega. This is the sensitivity of derivatives values to the volatility of the price of the underlying asset. Rho. This is the sensitivity of derivatives values to changes in the risk-free rate. Tail risk is the uncertainty about the probability of extreme (negative) outcomes. Commonly used measures of tail risk (sometimes referred to as downside risk) include Value at Risk and Conditional VaR. Value at risk (VaR) is the minimum loss over a period that will occur with a specific probability. Consider a bank that has a one-week VaR of 200 million euros with a probability of 30/0. That means that a one-week loss of at least 200 million euros is expected to occur 30/0 of the time. Note that this is not the maximum one-week loss the bank will experience; it is the minimum loss that will occur 30/0 of the time. VaR does not provide a maximum loss for a period. VaR has become accepted as a risk measure for banks and is used in establishing minimum capital requirements. There are various methods of calculating VaR, and both the inputs and models used will affect the calculated value, perhaps significantly. As is always the case with estimates of risk, incorrect inputs or inappropriate distribution assumptions will lead to misleading results. Given these limitations, VaR should be used in conjunction with other risk measures. Conditional VaR (CVaR) is the expected value of a loss, given that the loss exceeds a minimum amount. Relating this to the VaR measure presented above, the CVaR would be the expected loss, given that the loss was at least 200 million euros. It is calculated as the probability-weighted average loss for all losses expected to be at least 200 million euros. CVaR is similar to the measure of loss given default that is used in estimating risk for debt securities. Subjective and Market-Based Estimates of Risk Two methods of risk assessment that are used to supplement measures such as VaR and CVaR are stress testing and scenario analysis. Stress testing examines the effects of a specific (usually extreme) change in a key variable such as an interest rate or exchange rate. Scenario analysis refers to a similar what-if analysis of expected loss but incorporates changes in multiple inputs. A given scenario might combine an interest rate change with a significant change in oil prices or exchange rates. Page 130 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management:nA An Introduction Quantifying the risk to an organization of very infrequent events is quite difficult. The risk of the bankruptcy of a firm that has never experienced significant financial distress is often a subjective estimate rather than a data-driven estimate. Estimates of risk can also be based on the market prices of insurance, derivatives, or other securities that can be used to hedge those risks. These hedging costs provide information on market participants' aggregate estimate of the expected loss of specific risks. Operational risks are difficult to quantify for a single organization because they are very difficult to predict and may result in very large costs to the organization. One way to approach this problem is to examine a large sample of firms in order to determine an overall probability of significant losses due to operational risks and the average loss of firms that have experienced such losses. Unexpected changes in tax laws or the regulatory environment can impose large costs on an organization. The political nature of such changes makes them quite difficult to predict. Subjective estimates, rather than data-driven quantitative estimates, are necessary. As is often the case, even a subjective, non-quantitative estimate of risk probabilities and magnitudes is better than not addressing the risk factor at all. Modifying Risk Exposures Risk management does not seek to eliminate all risks. The goal is to retain the optimal mix of risks for the organization. This may mean taking on more of some risks, decreasing others, and eliminating some altogether. Once the risk management team has estimated various risks, management may decide to prevent or avoid a risk, accept a risk, transfer a risk, or shift a risk. One way to avoid a risk is to not engage in the activity with the uncertain outcome. If political risks in a country are to be avoided, simply not investing in securities of firms based in that country or not expanding a business enterprise to that country would avoid those risks. A decision to avoid certain risks typically would come from top management as a part of establishing the risk tolerance of the organization and would be instituted because the risks are judged to outweigh the potential benefits of specific activities. Some risks can be prevented. The risk of a data breach can be prevented with a greater level of security for the data and stronger processes. In this case, the benefits of reducing or eliminating the risk are judged to be greater than the cost of doing so. For risks that management has decided to bear, the organization will seek to bear them efficiently. Diversification may offer a way to more efficiently bear a specific risk. xwvutsrponmlkihgfedcaPNM Professor'sNote: We explain how diversification can reduce risk in the current topic area, Portfolio Management. eW Sometimes the term self-insurance is used to describe a situation where an organization has decided to bear a risk. Note, however, that this simply means that it will bear any associated losses from this risk factor. It is possible that this represents inaction rather than the result of analysis and strategic decision making. In some cases, the firm will ©20 15 Kaplan, Inc. Page 131 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management: An Introduction establish a reserve account to cover losses as a way of mitigating the impact of losses on the organization. For a risk an organization has decided not to bear, risk transfer or risk shifting can be employed. With a risk transfer, another party takes on the risk. Insurance is a type of risk transfer. The risk of fire destroying a warehouse complex is shifted to an insurance company by buying an insurance policy and paying the policy premiums. Insurance companies diversify across many risks so the premiums of some insured parties pay the losses of others. Ideally, the various risks the insurance company insures are not highly correlated, as that can reduce or eliminate any diversification benefits. An insurance company with highly correlated risks (or a single very large risk) may itself shift some of the resulting risk by buying reinsurance from another company. nA With a surety bond, an insurance company has agreed to make a payment if a third party fails to perform under the terms of a contract or agreement with the organization. For example, a company may be exposed to losses if a key supplier does not deliver on time, slowing a project and resulting in penalty payments by the company. Insurers also issue fidelity bonds, which will pay for losses that result from employee theft or misconduct. Managements that purchase insurance, surety bonds, or fidelity bonds have determined that the benefits of risk reduction are greater than the cost of the insurance. Risk shifting is a way to change the distribution of possible outcomes and is accomplished primarily with derivative contracts. For example, financial firms that do not want to bear currency risk on some foreign currency denominated debt securities can use forward currency contracts, futures contracts, or swaps to reduce or eliminate that risk. A firm with a large position in a specific stock can buy put options that provide a minimum sale price for the securities, altering the distribution of possible outcomes (in this case providing a floor value for the securities). On the other hand, a firm could sell call options on a specific stock, altering the distribution of possible outcomes by giving up some of the upside potential of the stock but decreasing its downside risk by the amount of the premiums received from the sale of the call options. Choosing Among Risk Modification Methods Organizations may use multiple methods of risk modification to reduce a single risk. The criterion is always a comparison of the costs and benefits of risk modification. Some risks may be mitigated by diversification, some shifted by insurance where it is available and economical, some shifted though the use of derivatives, and some simply borne or self-insured. The end result is a risk profile that matches the risk tolerance established for the organization and includes the risks that top management has determined match the goals of the organization in terms of cost versus potential returns. Page 132 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management:nA An Introduction LOS 42.a Risk management is the process of identifying and measuring the risks an organization (or portfolio manager or individual) faces, determining an acceptable level of overall risk (establishing risk tolerance), deciding which risks should be taken and which risks should be reduced or avoided, and putting the structure in place to maintain the bundle of risks that is expected to best achieve the goals of the organization. LOS 42.h An overall risk management framework should address the following activities: • Identifying and measuring existing risks. • Determining the organization's overall risk tolerance. • Establishing the processes and policies for risk governance. • Managing and mitigating risks to achieve the optimal bundle of risks. • Monitoring risk exposures over time. • Communicating across the organization. • Performing strategic risk analysis. LOS 42.c Risk governance refers to senior management's determination of the risk tolerance of the organization, the elements of its optimal risk exposure strategy, and the framework for oversight of the risk management function. LOS 42.d The risk tolerance for an organization is the overall amount of risk it will take in pursuing its goals and is determined by top management. LOS 42.e Risk budgeting is the process of allocating the total risk the firm will take (risk tolerance) to assets or investments by considering the risk characteristics of each and how they can be combined to best meet the organization's goals. The budget can be a single risk measure or the sum of various risk factors. LOS 42.£ Financial risks are those that arise from exposure to financial markets, including credit risk, liquidity risk, and market risk. Non-financial risks are the risks from the operation of the organization and from sources external to the organization. Individuals face mortality and longevity risk, in addition to financial risks. Interactions among risks are frequent and can be especially significant during periods of stress in financial markets. ©20 15 Kaplan, Inc. Page 133 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management: An Introduction LOS 42.g Risk of assets is measured by standard deviation, beta, or duration. Derivatives risk measures include delta, gamma, vega, and rho. Tail risk is measured with value at risk (VaR) or Conditional VaR. Some risks must be measured subjectively. An organization may decide to bear a risk (self-insurance), avoid or take steps to prevent a risk, efficiently manage a risk through diversification, transfer a risk with insurance or a surety bond, or shift a risk (change the distribution of uncertain outcomes) with derivatives. Organizations may use multiple methods of risk modification after considering the costs and benefits of the various methods. The end result is a risk profile that matches the organization's risk tolerance and includes the risks that top management has determined match the organization's goals. Page 134 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management:ncAAn Introduction 1. An investor has the most control over her portfolio's: A. risk. B. relative returns. c. risk-adjusted returns. 2. Effective risk management would most likely attempt to: A. maximize expected return for a given level of risk. B. minimize risk for a given level of expected return. c. reduce any significant risks the firm is exposed to. 3. Risk budgeting can best be described as: A. setting an annual limit on risk taken. B. selecting assets by their risk characteristics. c. establishing a maximum amount of risk to be taken. 4. Risk governance should most appropriately be addressed within an organization at the: A. enterprise level. B. business unit level. c. individual employee level. 5. Risk shifting is most likely achieved by: A. risk mitigation. B. using derivative securities. C. transferring risk to an insurance company. 6. Which of the following is most appropriately termed a financial risk? A. Credit risk. B. Solvency risk. C. Settlement risk. 7. A risk management framework least likely includes: A. risk governance, risk mitigation, and strategic risk analysis. B. identifying and measuring risks, risk policies and processes, and risk governance. C. risk mitigation, tracking the organization's risk profile, and establishing position limits. ytsrpomlkieba ©20 15 Kaplan, Inc. Page 135 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #42 - Risk Management: An Introduction Page 136 1. A An investor can select securities to achieve a given level of portfolio risk. Returns cannot be controlled. 2. A Risk management requires establishment of a risk tolerance (maximum acceptable level of risk) for the organization and will attempt to maximize expected returns for that level of risk. Some significant risks the firm is exposed to may be borne by the firm or even increased as a result of risk management. 3. B Risk budgeting refers to selecting assets or securities by their risk characteristics up to the maximum allowable amount of risk. The maximum amount of risk to be taken is established through risk governance. 4. A Risk governance should be approached from an enterprise view, with senior management determining risk tolerance and a risk management strategy on an organization-wide level. 5. B Risk shifting changes the distribution of possible outcomes, typically through the use of derivative securities. Risk shifting is one technique for mitigating risk. Transferring risk to an insurance company is termed risk transfer. 6. A The main sources of financial risk are market risk, credit risk, and liquidity risk. Solvency risk and settlement risk are classified as non-financial risks. 7. C A risk management framework includes the procedures, analytical tools, and infrastructure to conduct the risk governance process. It includes all of the items listed with the exception of establishing position limits, which is an example of the operational implementation of a system of risk management. ©2015 Kaplan, Inc. The following is a review of the Portfolio Management principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #43.UTSRPONLKIFEDA PORTFOLIO RISK AND RETURN: PART I I Study Session 12tnXMEA EXAM Focus This topic review makes use of many of the statistical and returns measures we covered in Quantitative Methods. You should understand the historical return and risk rankings of the major asset classes and how the correlation (covariance) of returns between assets and between various asset classes affects the risk of portfolios. Risk aversion describes an investor's preferences related to the tradeoff between risk and return. These preferences, along with the risk and return characteristics of available portfolios, can be used to illustrate the selection of an optimal portfolio for a given investor, that is, the portfolio that maximizes the investor's expected utility. LOS 43.a: Calculate and interpret major return measures and describe their • approprIate uses. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 320 Holding period return (HPR) is simply the percentage increase in the value of an investment over a given time period: ldi . d o lng perlo return = h end-of-period value 1 P + Div t 1 Pt - = t - = beginning-of-period value Po - Po + Div t Po If a stock is valued at €20 at the beginning of the period, pays €1 in dividends over the period, and at the end of the period is valued at £22, the HPR is: HPR= (22 + 1) /20-1 = 0.15 = 150/0 Average Returns The arithmetic mean return is the simple average of a series of periodic returns. It has the statistical property of being an unbiased estimator of the true mean of the underlying distribution .h of returns: . (R1 +R2 +R3 + ...+Rn) arrt rnetrc mean return = --=-----=-----=-------==-n ©20 15 Kaplan, Inc. Page 137 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I The geometric mean return is a compound annual rate. When periodic rates of return vary from period to period, the geometric mean return will have a value less than the arithmetic mean return: geometric mean return = ~(1 + R1)x (1 + R2)X (1 + R3) x ... x (1 + Rn)-l nA For example, for returns R, over three annual periods, the geometric mean return is calculated as follows: R Example: Return measures An investor purchased $1,000 of a mutual fund's shares. The fund had the following total returns over a 3-year period: +50/0,-80/0, +120/0.Calculate the value at the end of the 3-year period, the holding period return, the mean annual return, and the geometric mean annual return. Answer: Ending value = (1,000)(1.05)(0.92)(1.12) = $1,081.92. Holding period return = (1.05)(0.92)(1.12) - 1 = 0.08192 be calculated as 1,081.92/ 1,000 - 1 = 8.1920/0. = 8.1920/0, which can also Arithmetic mean return = (50/0- 80/0+ 120/0)/ 3 = 30/0. Geometric mean return = ~(1.05)(0.92)(1.12) -1 = 0.02659 = 2.660/0, which can also be calculated as geometric mean return = ~1 + HPR -1 = ~1.08192 -1 = 2.660/0. The money-weighted rate of return is the internal rate of return on a portfolio based on all of its cash inflows and outflows. To calculate a money-weighted rate of return, consider the beginning value and additional deposits of cash by the investor to be inflows and consider withdrawals of cash, interest, and dividends (which are additional cash available to be withdrawn) and the ending value to be outflows. Page 138 ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I Example: Money-weighted rate of return Assume an investor buys a share of stock for $80 at t = 0 and at the end of the next year (t = 1), she buys an additional share for $70. At the end of Year 2, the investor sells both shares for $85 each. At the end of each year in the holding period, the stock paid a $1.50 per share dividend. What is the money-weighted rate of return? t Answer: trpeS Step 1: Determine the timing of each cash flow and whether the cash flow is an inflow (+), into the account, or an outflow (-), available from the account. t = 0: purchase of first share - +$80.00 inflow to account t = 1: purchase of second share dividend from first share Subtotal, t = 1 = t = 2: dividend from two shares - -$3.00 proceeds from selling shares = -$170.00 Subtotal, t = 2 -$173.00 +$70.00 = -$1.50 +$68.50 inflow to account outflow from account Step 2: Net the cash flows for each time period and set the PV of cash inflows equal to the present value of cash outflows. PVinflows = PVoutflows $80 + $68.50 = $173.00 (l f-r) (l+r)2 Step 3: Solve for r to find the money-weighted rate of return. Net cash flows: CFo = +80; CF 1 = +68.5; CF2 = -173 The money-weighted rate of return is 10.350/0. In the previous example, the cash flows in and out of the account occur at l-year intervals so that we solved for an annual money-weighted rate of return. More generally, we must use the shortest period between significant cash flows into or out of the account when setting up the internal rate of return calculation. For example, if we use one month as our period (zero cash flow for months with no cash flows), the internal rate of return calculation will yield a monthly rate of return. In that case, we would need to compound the monthly money-weighted return for 12 months to translate it into an effective annual rate. Other Return Measures Gross return refers to the total return on a security portfolio before deducting fees for the management and administration of the investment account. Net return refers to the return after these fees have been deducted. Note that commissions on trades and other ©20 15 Kaplan, Inc. Page 139 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I costs that are necessary to generate the investment returns are deducted in both gross and net return measures. Pretax nominal return refers to the return prior to paying taxes. Dividend income, interest income, short-term capital gains, and long-term capital gains may all be taxed at different rates. After-tax nominal return refers to the return after the tax liability is deducted. Real return is nominal return adjusted for inflation. Consider an investor who earns a nominal return of 70/0 over a year when inflation is 2%. The investor's approximate real return is simply 7 - 2 ;:::50/0.The investor's exact real return is slightly lower, 1.07 / 1.02 - 1 ;:::0.049 ;:::4.9%. Real return measures the increase in an investor's purchasing power: how much more goods she can purchase at the end of one year due to the increase in the value of her investments. If she invests $1,000 and earns a nominal return of 70/0, she will have $1,070 at the end of the year. If the price of the goods she consumes has gone up 20/0, from $1.00 to $1.02, she will be able to consume 1,070/ 1.02;::: 1,049 units. She has given up consuming 1,000 units today but instead is able to purchase 1,049 units at the end of one year. Her purchasing power has gone up 4.9%; this is her real return. A leveraged return refers to a return to an investor that is a multiple of the return on the underlying asset. The leveraged return is calculated as the gain or loss on the investment as a percentage of an investor's cash investment. An investment in a derivative security, such as a futures contract, produces a leveraged return because the cash deposited is only a fraction of the value of the assets underlying the futures contract. Leveraged investments in real estate are very common: investors pay for only part of the cost of the property with their own cash, and the rest of the amount is paid for with borrowed money. nA LOS 43.b: Describe characteristics of the major asset classes that investors consider in forming portfolios. urpomligecaVPCA CPA ® Program Curriculum, Volume 4, page 320 An examination of the returns and standard deviation of returns for the major investable asset classes supports the idea of a tradeoff between risk and return. Using U.S. data over the period 1926-2008 as an example, shown in Figure 1, small-capitalization stocks have had the greatest average returns and greatest risk over the period. T-bills had the lowest average returns and the lowest standard deviation of returns. Page 140 ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I Figure 1: Risk and Return of Major Asset Classes in the United States (1926-2008)1 Average Annual Return (Geometric Mean) Standard Deviation (Annualized Monthly) Small-cap stocks 11.7% 33.0% Large-cap stocks 9.6% 20.9% Long-term corporate bonds 5.9% 8.4% Long-term Treasury bonds 5.7% 9.4% Treasury bills 3.7% 3.1% Inflation 3.0% 4.2% Assets Class zyvutsrponmlihgedcaVSRPMGFDCA Results for other markets around the world are similar: asset classes with the greatest average returns also have the highest standard deviations of returns. The annual nominal return on U.S. equities has varied greatly from year to year, ranging from losses greater than 400/0 to gains of more than 500/0. We can approximate the real returns over the period by subtracting inflation. The asset class with the least risk, T-bills, had a real return of only approximately 0.70/0 over the period, while the approximate real return on U.S. large-cap stocks was 6.60/0. Because annual inflation fluctuated greatly over the period, real returns have been much more stable than nominal returns. Evaluating investments using expected return and variance of returns is a simplification because returns do not follow a normal distribution; distributions are negatively skewed, with greater kurtosis (fatter tails) than a normal distribution. The negative skew reflects a tendency towards large downside deviations, while the positive excess kurtosis reflects frequent extreme deviations on both the upside and downside. These non-normal characteristics of skewness (7: 0) and kurtosis (7: 3) should be taken into account when analyzing investments. Liquidity is an additional characteristic to consider when choosing investments because liquidity can affect the price and, therefore, the expected return of a security. Liquidity can be a major concern in emerging markets and for securities that trade infrequently, such as low-quality corporate bonds. LOS 43.c: Calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data. CFA® Program Curriculum, Volume 4, page 332 Variance (Standard Deviation) of Returns for an Individual Security In finance, the variance and standard deviation of returns are common measures of investment risk. Both of these are measures of the variability of a distribution of returns about its mean or expected value. 1. 2009 Ibbotson SBBI Classic Yearbook. ©20 15 Kaplan, Inc. Page 141 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I We can calculate the population variance, (12, when we know the return R, for each period, the total number periods (T), and the mean or expected value of the population's distribution (1-1), as follows: TR tonlVTR T L:(Rt -1-1)2 (12 = --"t__:l:....__ _ T In the world of finance, we are typically analyzing only a sample of returns data, rather than the entire population. To calculate sample variance, ?, using a sample of T historical returns and the mean, R, of the observations, we use the following formula: tR S2 = -=t_1=--- _ T-l Covariance and Correlation of Returns for Two Securities Covariance measures the extent to which two variables move together over time. A positive covariance means that the variables (e.g., rates of return on two stocks) tend to move together. Negative covariance means that the two variables tend to move in opposite directions. A covariance of zero means there is no linear relationship between the two variables. To put it another way, if the covariance of returns between two assets is zero, knowing the return for the next period on one of the assets tells you nothing about the return of the other asset for the period. Here we will focus on the calculation of the covariance between two assets' returns using historical data. The calculation of the sample covariance is based on the following formula: n L:{[R ,l - R1][ R ,2 t CoV1,2 t R2]} C t=l = ....::.......;:;__--------- n-l where: R ~'t,l = return on Asset 1 in period t Rt,2 = return on Asset 2 in period t R, = mean return on Asset 1 R, = mean n return on Asset 2 = number of periods The magnitude of the covariance depends on the magnitude of the individual stocks' standard deviations and the relationship between their co-movements. Covariance is an absolute measure and is measured in return units squared. Page 142 ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I The covariance of the returns of two securities can be standardized by dividing by the product of the standard deviations of the two securities. This standardized measure of co-movement is called correlation and is computed as: COV1,2 P1,2 = 0'10'2 The relation can also be written as: The term Pl,2 is called the correlation coefficient between the returns of securities 1 and 2. The correlation coefficient has no units. It is a pure measure of the co-movement of the two stocks' returns and is bounded by -1 and + 1. utronlkifecaYSR How should you interpret the correlation coefficient? • • • A correlation coefficient of + 1 means that deviations from the mean or expected return are always proportional in the same direction. That is, they are perfectly positively correlated. A correlation coefficient of-1 means that deviations from the mean or expected return are always proportional in opposite directions. That is, they are perfectly negatively correlated. A correlation coefficient of zero means that there is no linear relationship between the two stocks' returns. They are uncorrelated. One way to interpret a correlation (or covariance) of zero is that, in any period, knowing the actual value of one variable tells you nothing about the value of the other. Example: Calculating mean return, returns variance, returns covariance, and correlation Given the six years of percentage returns for Stocks 1 and 2 in the following table, calculate the mean return, sample variance, sample covariance, and correlation for the • two returns series. Year Stock 1 Return Stock 2 Return 20X4 +0.10 +0.20 +0.05 +0.10 +0.005 20X5 -0.15 -0.20 -0.20 -0.30 +0.060 20X6 +0.20 -0.10 +0.15 -0.20 -0.030 20X7 +0.25 +0.30 +0.20 +0.20 +0.040 20X8 -0.30 -0.20 -0.35 -0.30 +0.105 20X9 +0.20 +0.60 +0.15 +0.50 +0.075 L:Rl = 0.30 Rl = 0.05 L:R2 = 0.60 R2 = 0.10 ©20 15 Kaplan, Inc. E = 0.255 Page 143 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I Answer: To calculate the mean returns for the samples, we sumthe returns for each stock and divide by the number of years. The mean returns are Rr = 30 / 6 = 50/0for Stock 1 and R2 = 60 / 6 = 100/0for Stock 2. rR Using the deviations of each year's returns from the mean return for Stock 1, we can calculate the sample variance as follows: 2 (0.05)2 +(-0.20)2 sl = +(0.15)2 +(0.20)2 +(-0.35)2 +(0.15)2 6-1 = 0.05 Using the deviations of each year's returns from the mean return for Stock 2, we can calculate the sample variance as follows: s~ = (0.10)2 +(-0.30)2 +(-0.20)2 +(0.20)2 +(-0.30)2 6-1 +(0.50)2 =0.104 In the right-hand column of the table, we have summed the products of the deviations of Stocks 1 and 2 from their means to get 0.255. The sample covariance is calculated as 0.255 / (6 - 1) = 0.051. To convert the covariance into correlation, we use the sample standard deviations of returns for the two stocks: sl = JO.05 = 0.2236 = 22.360/0 urpomligecaVPOJCA s2 = ..)0.104 = 0.3225 = 32.250/0 Finally, we can calculate the correlation coefficient for the two stocks' returns as follows: LOS 43.d: Explain risk aversion and its implications for portfolio selection. CPA ® Program Curriculum, Volume 4, page 343 A risk-averse investor is simply one that dislikes risk (i.e., prefers less risk to more risk). Given two investments that have equal expected returns, a risk-averse investor will choose the one with less risk (standard deviation, 0-). Page 144 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I A risk-seeking (risk-loving) investor actually prefers more risk to less and, given equal expected returns, will choose the more risky investment. A risk-neutral investor has no preference regarding risk and would be indifferent between two such investments. Consider this gamble: A coin will be flipped; if it comes up heads, you receive $100; if it comes up tails, you receive nothing. The expected payoff is 0.5($100) + 0.5($0) == $50. A risk-averse investor would choose a payment of $50 (a certain outcome) over the gamble. A risk-seeking investor would prefer the gamble to a certain payment of $50. A riskneutral investor would be indifferent between the gamble and a certain payment of $50. If expected returns are identical, a risk-averse investor will always choose the investment with the least risk. However, an investor may select a very risky portfolio despite being risk averse; a risk-averse investor will hold very risky assets if he feels that the extra return he expects to earn is adequate compensation for the additional risk. LOS 43.e: Calculate and interpret portfolio standard deviation. wurpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 352 The variance of returns for a portfolio of two risky assets is calculated as follows: where wI is the proportion of the portfolio invested in Asset 1, and w2 is the proportion of the portfolio invested in Asset 2. w2 must equal (1 - wI). wI Previously, we established that the correlation of returns for two assets is calculated as: COVI2 . PI2 = , so that we can also wnte CovI2 = PI20"10"2. 0"10"2 Substituting this term for Cov 12 in the formula for the variance of returns for a portfolio of two risky assets, we have the following: Var POrtIOc 1.10 = wtO"r + w~O"~+ 2wI w2PI20"10"2 Because Varportfolio= O"~ortfolio: Writing the formula in this form allows us to easily see the effect of the correlation of returns between the two assets on portfolio risk. ©20 15 Kaplan, Inc. Page 145 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I LOS 43.f: Describe the effect on a portfolio's risk of investing in assets that are less than perfectly correlated. yxwvutsrqponmlihgfedcbaVTPNIFCA CFA® Program Curriculum, Volume 4, page 357 If two risky asset returns are perfectly positively correlated, p 12 == + 1, then the square root of portfolio variance (the portfolio standard deviation of returns) is equal to: p Professor's Note: This might be easier to see by examining the algebra in reverse. Ifw1(J1 + w2(J2 equals the square root of the term under the radical in this special case, then (wI (J 1 + w2(J ~2 should equal the term under the radical. If we expand (toj(J 1 + w2(J ~2, we get: jaPJ In this unique case, with p 12 == 1, the portfolio standard deviation is simply a weighted average of the standard deviations of the individual asset returns. A portfolio 250/0 invested in Asset 1 and 750/0invested in Asset 2 will have a standard deviation of returns equal to 250/0of the standard deviation (a 1) of Asset 1's return, plus 750/0of the standard deviation (a2) of Asset 2's return. Focusing on returns correlation, we can see that the greatest portfolio risk results when the correlation between asset returns is + 1. For any value of correlation less than + 1, portfolio variance is reduced. Note that for a correlation of zero, the entire third term in the portfolio variance equation is zero. For negative values of correlation P12' the third term becomes negative and further reduces portfolio variance and standard deviation. We will illustrate this property with an example. Example: Portfolio risk as correlation varies Consider two risky assets that have returns variances of 0.0625 and 0.0324, respectively. The assets' standard deviations of returns are then 250/0and 180/0, respectively. Calculate the variances and standard deviations of portfolio returns for an equal-weighted portfolio of the two assets when their correlation of returns is 1, 0.5, 0, and -0.5. Page 146 ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I The calculations are as follows: o portfolio= ~varianceportfolio 0portfolio= Jwror p = correlation + w~o~ + 2wl w2Pi20102 = + 1: o = portfolio standard deviation = 0.5(250/0) + 0.5(180/0) = 21.50/0 02 = portfolio variance = 0.2152 = 0.046225 p = correlation = 0.5: 02 = (0.52)0.0625 + (0.52)0.0324 + 2(0.5)(0.5)(0.5)(0.25)(0.18) + (0.52)0.0324 = + (0.52)0.0324 + 2(0.5)(0.5)(-0.5)(0.25)(0.18) = 0.034975 o = 18.700/0 p = correlation = 0: 02 = (0.52)0.0625 0.023725 o = 15.400/0 p = correlation = -0.5: 02 = (0.52)0.0625 = 0.012475 o = 11.170/0 Note that portfolio risk falls as the correlation between the assets' returns decreases. This is an important result of the analysis of portfolio risk: The lower the correlation of asset returns, the greater the risk reduction (diversification) benefit of combining assets in a portfolio. If asset returns were perfectly negatively correlated, portfolio risk could be eliminated altogether for a specific set of asset weights. We show these relations graphically in Figure 2 by plotting the portfolio risk and return for all portfolios of two risky assets, for assumed values of the assets' returns correlation. ©20 15 Kaplan, Inc. Page 147 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I Figure 2: Risk and Return for Different Values of p pRE E(R) p 100% Asset B .~ • .. " ...... ...... ..... ,.. • .. '" .. ... .. .. ... ..... ,• p =-1 •• .... • p = -0.5 :, ,, , .......... p= • ... ... ... •• .. • . ..'. .. ........ ........ ..... .. ... ... '* ,. • ",,'" .>: ... .." ... , • .. • .. • ,," .. ..... urpomligecaVPCA ." ..' • , • ,, • 0,', p = +0.5," ~ .. , ,, ', , ,, , • ......... • ...... ............ ' ' p = +1 1 100% Asset Arc ~-------------------------------------------------cr p From these analyses, the risk-reduction benefits of investing in assets with low return correlations should be clear. The desire to reduce risk is what drives investors to invest in not just domestic stocks, but also bonds, foreign stocks, real estate, and other assets. LOS 43.g: Describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio. CPA ® Program Curriculum, Volume 4, page 364 For each level of expected portfolio return, we can vary the portfolio weights on the individual assets to determine the portfolio that has the least risk. These portfolios that have the lowest standard deviation of all portfolios with a given expected return are known as minimum-variance portfolios. Together they make up the minimum-variance frontier. Assuming that investors are risk averse, investors prefer the portfolio that has the greatest expected return when choosing among portfolios that have the same standard deviation of returns. Those portfolios that have the greatest expected return for each level of risk (standard deviation) make up the efficient frontier. The efficient frontier coincides with the top portion of the minimum-variance frontier. A risk-averse investor would only choose portfolios that are on the efficient frontier because all available portfolios that are not on the efficient frontier have lower expected returns than an efficient portfolio with the same risk. The portfolio on the efficient frontier that has the least risk is the global minimum-variance portfolio. These concepts are illustrated in Figure 3. Page 148 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I Figure 3: Minimum-Variance and Efficient Frontiers E(R) Global MinimumVariance PortfolionIA • • • \ • , ... ... ... .. .. .. .. • • ~ • Efficient Frontier (All Efficient Portfolios) • rcL Inefficient Portfolios • ~ .. .. .. .... Individual Security • • ...... ...... - __• .. __ • ------ L--------------------------------------------------cr LOS 43.h: Explain the selection of an optimal portfolio, given an investor's utility (or risk aversion) and the capital allocation line. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 370 An investor's utility function represents the investor's preferences in terms of risk and return (i.e., his degree of risk aversion). An indifference curve is a tool from economics that, in this application, plots combinations of risk (standard deviation) and expected return among which an investor is indifferent. In constructing indifference curves for portfolios based on only their expected return and standard deviation of returns, we are assuming that these are the only portfolio characteristics that investors care about. In Figure 4, we show three indifference curves for an investor. The investor's expected utility is the same for all points along a single indifference curve. Indifference curve II represents the most preferred portfolios in Figure 4; our investor will prefer any portfolio along II to any portfolio on either 12 or 13. ©20 15 Kaplan, Inc. Page 149 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I Figure 4: Risk-Averse Investor's Indifference Curves RE E(R)rcL L--------------------------------------------------cr Indifference curves slope upward for risk-averse investors because they will only take on more risk (standard deviation of returns) if they are compensated with greater expected returns. An investor who is relatively more risk averse requires a relatively greater increase in expected return to compensate for a given increase in risk. In other words, a more risk-averse investor will have steeper indifference curves, reflecting a higher risk aversion coefficient. In our previous illustration of efficient portfolios available in the market, we included only risky assets. Now we will introduce a risk-free asset into our universe of available assets, and we will consider the risk and return characteristics of a portfolio that combines a portfolio of risky assets and the risk-free asset. Recall from Quantitative Methods that we can calculate the expected return and standard deviation of a portfolio with weight WA allocated to risky Asset A and weight WB allocated to risky Asset Busing the following formulas: WA Allow Asset B to be the risk-free asset and Asset A to be the risky asset portfolio. Because a risk-free asset has zero standard deviation and zero correlation of returns with those of a risky portfolio, this results in the reduced equation: The intuition of this result is quite simple: If we put X% of our portfolio into the risky asset portfolio, the resulting portfolio will have standard deviation of returns equal to X% of the standard deviation of the risky asset portfolio. The relationship between portfolio risk and return for various portfolio allocations is linear, as illustrated in Figure 5. Page 150 ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I Combining a risky portfolio with a risk-free asset is the process that supports the twofund separation theorem, which states that all investors' optimum portfolios will be made up of some combination of an optimal portfolio of risky assets and the risk-free asset. The line representing these possible combinations of risk-free assets and the optimal risky asset portfolio is referred to as the capital allocation line. Point X on the capital allocation line in Figure 5 represents a portfolio that is 400/0 invested in the risky asset portfolio and 600/0 invested in the risk-free asset. Its expected return will be 0.40 [E(Rrisky asset portfolio)] + 0.60(Rf), and its standard deviation will be pcXRE 0.40 (c risky asset portfolio)· Figure 5: Capital Allocation Line and Risky Asset Weights E(R) E(R . .) - -- - .. nsky portfolio E(R) -- - - Capital Allocation LineRE X op cr risky porrfolio Now that we have constructed a set of the possible efficient portfolios (the capital allocation line), we can combine this with indifference curves representing an individual's preferences for risk and return to illustrate the logic of selecting an optimal portfolio (i.e., one that maximizes the investor's expected utility). In Figure 6, we can see that Investor A, with preferences represented by indifference curves 11' 12, and 13, can reach the level of expected utility on 12 by selecting portfolio X. This is the optimal portfolio for this investor, as any portfolio that lies on 12 is preferred to all portfolios that lie on 13 (and in fact to any portfolios that lie between 12 and 13). Portfolios on 11 are preferred to those on 12, but none of the portfolios that lie on 11 are available in the market. ©20 15 Kaplan, Inc. Page 151 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I Figure 6: Risk-Averse Investor's Indifference Curves RE E(R) Capital Allocation Line The final result of our analysis here is not surprising; investors who are less risk averse will select portfolios that are more risky. Recall that the less an investor's risk aversion, the flatter his indifference curves. As illustrated in Figure 7, the flatter indifference curve for Investor B (fB) results in an optimal (tangency) portfolio that lies to the right of the one that results from a steeper indifference curve, such as that for Investor A (fA). An investor who is less risk averse should optimally choose a portfolio with more invested in the risky asset portfolio and less invested in the risk-free asset. fA B Figure 7: Portfolio Choices Based on Investor's Indifference Curves E(R) Capital Allocation LinercL L--------------------------------------------------cr Page 152 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I LOS 43.a Holding period return is used to measure an investment's return over a specific period. Arithmetic mean return is the simple average of a series of periodic returns. Geometric mean return is a compound annual rate. Money-weighted rate of return is the IRR calculated using periodic cash flows into and out of an account and is the discount rate that makes the present value of cash inflows equal to the present value of cash outflows. Gross return is total return after deducting commissions on trades and other costs necessary to generate the returns, but before deducting fees for the management and administration of the investment account. Net return is the return after management and administration fees have been deducted. Pretax nominal return is the numerical percentage return of an investment, without considering the effects of taxes and inflation. After-tax nominal return is the numerical return after the tax liability is deducted, without adjusting for inflation. Real return is the increase in an investor's purchasing power, roughly equal to nominal return minus inflation. Leveraged return is the gain or loss on an investment as a percentage of an investor's cash investment. LOS 43.h As predicted by theory, asset classes with the greatest average returns have also had the highest risk. Some of the major asset classes that investors consider when building a diversified portfolio include small-capitalization stocks, large-capitalization stocks, long-term corporate bonds, long-term Treasury bonds, and Treasury bills. In addition to risk and return, when analyzing investments, investors also take into consideration an investment's liquidity, as well as non-normal characteristics such as skewness and kurtosis. ©20 15 Kaplan, Inc. Page 153 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I LOS 43.c We can calculate the population variance, (J'2, aTRJ when we know the return R, for period t, tLJ the total number T of periods, and the mean J-L of the population's distribution: population variance S = a2 = --"t,-"I,___ _ T In finance, we typically analyze only a sample of returns, so the sample variance applies instead: sample variance = S2 = --"t'-"I'----- _ T-l Covariance measures the extent to which two variables move together over time. Positive covariance means the variables (e.g., rates of return on two stocks) tend to move together. Negative covariance means that the two variables tend to move in opposite directions. Covariance of zero means there is no linear relationship between the two variables. Correlation is a standardized measure of co-movement that is bounded by -1 and + 1: LOS 43.d A risk-averse investor is one that dislikes risk. Given two investments that have equal expected returns, a risk-averse investor will choose the one with less risk. However, a risk-averse investor will hold risky assets if he feels that the extra return he expects to earn is adequate compensation for the additional risk. Assets in the financial markets are priced according to the preferences of risk-averse investors. A risk-seeking (risk-loving) investor actually prefers more risk to less and, given investments with equal expected returns, will choose the more risky investment. A risk-neutral investor has no preference regarding risk and would be indifferent between two investments with the same expected return but different standard deviation of returns. LOS 43.e The standard deviation of returns for a portfolio of two risky assets is calculated as follows: Page 154 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I LOS 43.f The greatest portfolio risk will result when the asset returns are perfectly positively correlated. As the correlation decreases from + 1 to -1, portfolio risk decreases. The lower the correlation of asset returns, the greater the risk reduction (diversification) benefit of combining assets in a portfolio. LOS 43.g For each level of expected portfolio return, the portfolio that has the least risk is known as a minimum-variance portfolio. Taken together, these portfolios form a line called the minimum-variance frontier. On a risk versus return graph, the one risky portfolio that is farthest to the left (has the least risk) is known as the global minimum-variance portfolio. Those portfolios that have the greatest expected return for each level of risk make up the efficient frontier. The efficient frontier coincides with the top portion of the minimum variance frontier. Risk-averse investors would only choose a portfolio that lies on the efficient frontier. LOS 43.h An indifference curve plots combinations of risk and expected return that an investor finds equally acceptable. Indifference curves generally slope upward because risk-averse investors will only take on more risk if they are compensated with greater expected returns. A more risk-averse investor will have steeper indifference curves. Flatter indifference curves (less risk aversion) result in an optimal portfolio with higher risk and higher expected return. An investor who is less risk averse will optimally choose a portfolio with more invested in the risky asset portfolio and less invested in the riskfree asset. ©20 15 Kaplan, Inc. Page 155 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I 1. ncA An investor buys a share of stock for $40 at time t == 0, buys another share of the same stock for $50 at t == 1, and sells both shares for $60 each at t == 2. The stock paid a dividend of $1 per share at t == 1 and at t == 2. The periodic moneyweighted rate of return on the investment is closest to: A. 22.20/0. B. 23.00/0. c. 23.80/0. utsromleca 2. Which of the following asset classes has historically had the highest returns and standard deviation? A. Small-cap stocks. B. Large-cap stocks. C. Long-term corporate bonds. 3. In a 5-year period, the annual returns on an investment are 50/0,-30/0, -40/0, 20/0, and 60/0.The standard deviation of annual returns on this investment is closest to: A. 4.00/0. B. 4.50/0. C. 20.70/0. B Page 156 4. A measure of how the returns of two risky assets move in relation to each other is the: A. range. B. covariance. C. standard deviation. 5. Which of the following statements about correlation is least accurate? A. Diversification reduces risk when correlation is less than + 1. B. If the correlation coefficient is 0, a zero variance portfolio can be constructed. C. The lower the correlation coefficient, the greater the potential benefits from diversification. 6. The variance of returns is 0.09 for Stock A and 0.04 for Stock B. The covariance between the returns of A and B is 0.006. The correlation of returns between A and B is: A. 0.10. B. 0.20. C. 0.30. 7. Which of the following statements about risk-averse investors is most accurate? A risk-averse investor: A. seeks out the investment with minimum risk, while return is not a major consideration. B. will take additional investment risk if sufficiently compensated for this risk. C. avoids participating in global equity markets. ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I Use the following data to answer Questions 8 and 9. A portfolio was created by investing 250/0of the funds in Asset A (standard deviation 150/0)and the balance of the funds in Asset B (standard deviation = 100/0). = 8. If the correlation coefficient is 0.75, what is the portfolio's standard deviation? A. 10.60/0. B. 12.40/0. C. 15.00/0. 9. If the correlation coefficient is -0.75, what is the portfolio's standard deviation? A. 2.80/0. B. 4.20/0. C. 5.30/0. 10. Which of the following statements about covariance and correlation is least accurate? A. A zero covariance implies there is no linear relationship between the returns on two assets. B. If two assets have perfect negative correlation, the variance of returns for a portfolio that consists of these two assets will equal zero. C. The covariance of a 2-stock portfolio is equal to the correlation coefficient times the standard deviation of one stock's returns times the standard deviation of the other stock's returns. 11. Which of the following available portfolios most likely falls below the efficient frontier? Expected Expected Portfolio return standard deviation 7% A. A 140/0 9% B. B 260/0 C. C 120/0 220/0 yutsromlkieca B 12. The capital allocation line is a straight line from the risk-free asset through the: A. global maximum-return portfolio. B. optimal risky portfolio. C. global minimum-variance portfolio. ©20 15 Kaplan, Inc. Page 157 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I 1. C Using the cash flow functions on your financial calculator, enter CFOfA= -40; CFl = -50 + 1 = -49; CF2 = 60 x 2 + 2 = 122; CPT IRR = 23.820/0. 2. A Small-cap stocks have had the highest annual return and standard deviation of return over time. Large-cap stocks and bonds have historically had lower risk and return than small-cap stocks. 3. B Mean annual return = (5% - 3% - 40/0 + 20/0 + 6%) / 5 = 1.20/0 Squared deviations from the mean: 3.82 = 14.44 -4.22 = 17.64 -5.22 = 27.04 0.82 = 0.64 4.82 = 23.04 50/0- 1.2% = 3.8% -3% -1.2% = -4.20/0 -4% -1.2% = -5.20/0 20/0-1.2% = 0.8% 60/0-1.2% = 4.8% Sum of squared deviations Sample variance = = 14.44 + 17.64 + 27.04 + 0.64 + 23.04 82.8 / (5 - 1) Sample standard deviation = 82.8 20.7 =J 20.71/2 = 4.55% 4. B The covariance is defined as the co-movement of the returns of two assets or how well the returns of two risky assets move together. Range and standard deviation are measures of dispersion and measure risk, not how assets move together. 5. B A zero-variance portfolio can only be constructed if the correlation coefficient between assets is -1. Diversification benefits can be had when correlation is less than +1, and the lower the correlation, the greater the potential benefit. 6. A -fA = -J0.09 = 0.30 -JB = .j0.04 = 0.20 Correlation 0.006 / [(0.30)(0.20)] jJ = = 0.10 7. B Risk-averse investors are generally willing to invest in risky investments, if the return of the investment is sufficient to reward the investor for taking on this risk. Participants in securities markets are generally assumed to be risk-averse investors. 8. A ~(0.25)2(0.15)2 + (0.75)2(0.10)2 + 2(0.25)(0.75)(0.15)(0.10)(0.75) .J0.001406 + 0.005625 +0.004219 9. C = = .J0.01125 = 0.106 = 10.60/0 ~(0.25)2 (0.15)2 + (0.75)2 (0.10)2 + 2(0.25)(0.75)(0.15)(0.10)( -0.75) = .J0.001406 + 0.005625 - 0.004219 = .J0.002812 = 0.053 = 5.3% Page 158 = ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #43 - Portfolio Risk and Return: Part I 10. B If the correlation of returns between the two assets is -1, the set of possible portfolio risk/return combinations becomes two straight lines (see Figure 2). A portfolio of these two assets will have a positive returns variance unless the portfolio weights are those that minimize the portfolio variance. Covariance is equal to the correlation coefficient multiplied by the product of the standard deviations of the returns of the two stocks in a 2-stock portfolio. If covariance is zero, then correlation is also zero, which implies that there is no linear relationship between the two stocks' returns. 11. B Portfolio B must be the portfolio that falls below the Markowitz efficient frontier because there is a portfolio (Portfolio C) that offers a higher return and lower risk. 12. B An investor's optimal portfolio will lie somewhere on the capital allocation line, which begins at the risk-free asset and runs through the optimal risky portfolio. ©20 15 Kaplan, Inc. Page 159 The following is a review of the Portfolio Management principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #44.UTSRPONLKIFEDA PORTFOLIO RISK AND RETURN: PART I II Study Session 12XMEBA EXAM Focus The concepts developed here are very important to finance theory and are also used extensively in practice. You must know this material completely-not only the formulas and definitions, but the ideas that underlie their use. A model assumption that diversification is costless leads to the conclusion that only systematic risk (which cannot be reduced by further diversification) is priced in equilibrium, so that bearing nonsystematic risk does not increase expected returns. LOS 44.a: Describe the implications of combining a risk-free asset with a portfolio of risky assets. urpomligecaWVPCA CPA ® Program Curriculum, Volume 4, page 390 In the previous topic review, we covered the mathematics of calculating the risk and return of a portfolio with a percentage weight of WA invested in a risky portfolio (P) and a weight ofW B = 1 - WA invested in a risk-free asset. Because a risk-free asset has zero standard deviation and zero correlation of returns with a risky portfolio, allowing Asset B to be the risk-free asset and Asset A to be the risky asset portfolio results in the following reduced equation: O"p = ~WXO"~ = WAO"A Our result is that the risk (standard deviation of returns) and expected return of portfolios with varying weights in the risk-free asset and a risky portfolio can be plotted as a line that begins at the risk-free rate of return and extends through the risky portfolio. This result is illustrated in Figure 1. Page 160 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Figure 1: Combining a Risk-Free Asset with a Risky Asset oEA E(~) ~ Risky AssetRE E(Rportfolio.) - -- - -- - -- -- - -- -- - -- -- - -- -- - -- -- - - Portfolio with WA Invested in the Risky Asset n, ~ Risk-Free AssetrocW ~----------------------~-----------------------cr o oportfolio =Wcr A A LOS 44.b: Explain the capital allocation line (CAL) and the capital market line (CML). urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 390 The line of possible portfolio risk and return combinations given the risk-free rate and the risk and return of a portfolio of risky assets is referred to as the capital allocation line (CAL). For an individual investor, the best CAL is the one that offers the mostpreferred set of possible portfolios in terms of their risk and return. Figure 2 illustrates three possible investor CALs for three different risky portfolios A, B, and C. The optimal risky portfolio for this investor is Portfolio A because it results in the most preferred set of possible portfolios constructed by combining the risk-free asset with the risky portfolio. Of all the portfolios available to the investor, a combination of the riskfree asset with risky Portfolio A offers the investor the greatest expected utility. ©20 15 Kaplan, Inc. Page 161 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Figure 2: Risky Portfolios and Their Associated Capital Allocation Lines RE E(R)rc ~-------------------------------------------------cr If each investor has different expectations about the expected returns of, standard deviations of, or correlations between risky asset returns, each investor will have a different optimal risky asset portfolio and a different CAL. A simplifying assumption underlying modern portfolio theory (and the capital asset pricing model, which is introduced later in this topic review) is that investors have homogeneous expectations (i.e., they all have the same estimates of risk, return, and correlations with other risky assets for all risky assets). Under this assumption, all investors face the same efficient frontier of risky portfolios and will all have the same optimal risky portfolio and CAL. Figure 3 illustrates the determination of the optimal risky portfolio and optimal CAL for all investors under the assumption of homogeneous expectations. Note that, under this assumption, the optimal CAL for any investor is the one that is just tangent to the efficient frontier. Depending on their preferences for risk and return (their indifference curves), investors may choose different portfolio weights for the risk-free asset and the risky (tangency) portfolio. Every investor, however, will use the same risky portfolio. When this is the case, that portfolio must be the market portfolio of all risky assets because all investors that hold any risky assets hold the same portfolio of risky assets. Page 162 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Figure 3: Determining the Optimal Risky Portfolio and Optimal CAL Assuming Homogeneous Expectations pfRME E(R) Capital Market Line Optimal Risky Portfolio (Market Portfolio) ~ R frc Efficient Frontier Risk-Free Asset ~-----------------------------------------------cr Under the assumption of homogeneous expectations, this optimal CAL for all investors is termed the capital market line (CML). Along this line, expected portfolio return, E(Rp)' is a linear function of portfolio risk, O"p. The equation of this line is as follows: pO - R E(Rp ) f + E(RM)-Rf pfaR apaM aM The y-intercept of this line is Rf and the slope (rise over run) of this line is as follows: E(RM)-Rf aM The intuition of this relation is straightforward. An investor who chooses to take on no risk (ap = 0) will earn the risk-free rate, Rf" The difference between the expected return on the market and the risk-free rate is termed the market risk premium. If we rewrite the CML equation as E(Rp) = Rf + (E(RM) - Rf) ap aM we can see that an investor can expect to get one unit of market risk premium in additional return (above the risk-free rate) for every unit of market risk, 0" M' that the investor is willing to accept. If we assume that investors can both lend (invest in the risk-free asset) at the riskfree rate and borrow (as with a margin account) at the risk-free rate, they can select portfolios to the right of the market portfolio in Figure 3. An example will illustrate the calculations. ©20 15 Kaplan, Inc. Page 163 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Example: Portfolio risk and return with borrowing and lending Assume that the risk-free rate, Rf, is 50/0; the expected rate of return on the market, ECRM), is 110/0; and that the standard deviation of returns on the market portfolio, aM' is 200/0. Calculate the expected return and standard deviation of returns for portfolios that are 250/0, 750/0, and 1250/0 invested in the market portfolio. We will use RM to represent these portfolio weights. fRM feWRMI a Expected portfolio returns are calculated as ECRp) :::(I - WM) x R, + WM x ECRM), so we have the following: W M :::250/0: ECRp)::: 0.75 x 50/0 + 0.25 x 11 % ::: 6.50/0 W M :::750/0: ECRp)::: 0.25 x 50/0 + 0.75 x 11 % ::: 9.50/0 WM::: 125%: ECRp) :::-0.25 x 5% + 1.25 x 11 % ::: 12.5% Portfolio standard deviation is calculated as (Jp :::W M x (JM' so we have the following: (Jp ::: 0.25 x 200/0 ::: 50/0 (Jp ::: 0.75 x 200/0 ::: 150/0 (Jp::: 1.25 x 200/0 ::: 250/0 Figure 4: Borrowing and Lending Portfolios ECR) EC~) ::: 11 % f-------~--:-o\;-::\.o7'"S -------::::::::=:::~M - - - - 1\.O:\.~~ ~()\:~ - \_.e WM ::: 7 0/0 I I Rf-- 50/0 I WM::: 250/0 (JM :::200/0 Page 164 ©2015 Kaplan, Inc. (J Cross-Reference Study Session 12 to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Note that with a weight (of investor assets) of 1250/0 in the market portfolio, the investor borrows an amount equal to 25% of his portfolio assets at 50/0. An investor with $10,000 would then borrow $2,500 and invest a total of $12,500 in the market portfolio. This leveraged portfolio will have an expected return of 12.50/0 and standard deviation of 250/0. nA Investors who believe market prices are informationally efficient often follow a passive investment strategy (i.e., invest in an index of risky assets that serves as a proxy for the market portfolio and allocate a portion of their investable assets to a risk-free asset, such as short-term government securities). In practice, many investors and portfolio managers believe their estimates of security values are correct and market prices are incorrect. Such investors will not use the weights of the market portfolio but will invest more than the market weights in securities that they believe are undervalued and less than the market weights in securities which they believe are overvalued. This is referred to as active portfolio management to differentiate it from a passive investment strategy that utilizes a market index for the optimal risky asset portfolio. LOS 44.c: Explain systematic and nonsystematic risk, including why an investor should not expect to receive additional return for bearing nonsystematic risk. wvutsrqponmlkihgfedcbaVPNKCA CPA ® Program Curriculum, Volume 4, page 402 When an investor diversifies across assets that are not perfectly correlated, the portfolio's risk is less than the weighted average of the risks of the individual securities in the portfolio. The risk that is eliminated by diversification is called unsystematic risk (also called unique, diversifiable, or firm-specific risk). Because the market portfolio contains all risky assets, it must be a well-diversified portfolio. All the risk that can be diversified away has been. The risk that remains cannot be diversified away and is called the systematic risk (also called nondiversifiable risk or market risk). The concept of systematic risk applies to individual securities as well as to portfolios. Some securities' returns are highly correlated with overall market returns. Examples of firms that are highly correlated with market returns are luxury goods manufacturers such as Ferrari automobiles and Harley Davidson motorcycles. These firms have high systematic risk (i.e., they are very responsive to market, or systematic, changes). Other firms, such as utility companies, respond very little to changes in the systematic risk factors. These firms have very little systematic risk. Hence, total risk (as measured by standard deviation) can be broken down into its component parts: unsystematic risk and systematic risk. Mathematically: total risk == systematic risk + unsystematic risk Professor's Note: Know this concept! Do you actually have to buy all the securities in the market to diversify away unsystematic risk? No. Academic studies have shown that as you increase the number of stocks in a portfolio, the portfolio's risk falls toward the level of market risk. One ©20 15 Kaplan, Inc. Page 165 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II study showed that it only took about 12 to 18 stocks in a portfolio to achieve 900/0 of the maximum diversification possible. Another study indicated it took 30 securities. Whatever the number, it is significantly less than all the securities. Figure 5 provides a general representation of this concept. Note, in the figure, that once you get to 30 or so securities in a portfolio, the standard deviation remains constant. The remaining risk is systematic, or nondiversifiable, risk. We will develop this concept later when we discuss beta, a measure of systematic risk. la Figure 5: Risk vs. Number of Portfolio Assets o (Risk) Total Risk unsystema~ic ~isk) ( + systematIc risk Unsystematic Risk Market Riskt (Omkt) [=-~tL=~=-_-===::::==:::::::::===~,,-----_ t Systematic Risk t Number of securities in the portfolio :::::30 Systematic Risk is Relevant in Portfolios One important conclusion of capital market theory is that equilibrium security returns depend on a stock's or a portfolio's systematic risk, not its total risk as measured by standard deviation. One of the assumptions of the model is that diversification is free. The reasoning is that investors will not be compensated for bearing risk that can be eliminated at no cost. If you think about the costs of a no-load index fund compared to buying individual stocks, diversification is actually very low cost if not actually free. The implications of this conclusion are very important to asset pricing (expected returns). The riskiest stock, with risk measured as standard deviation of returns, does not necessarily have the greatest expected return. Consider a biotech stock with one new drug product that is in clinical trials to determine its effectiveness. If it turns out that the drug is effective and safe, stock returns will be quite high. If, on the other hand, the subjects in the clinical trials are killed or otherwise harmed by the drug, the stock will fall to approximately zero and returns will be quite poor. This describes a stock with high standard deviation of returns (i.e., high total risk). The high risk of our biotech stock, however, is primarily from firm-specific factors, so its unsystematic risk is high. Because market factors such as economic growth rates have little to do with the eventual outcome for this stock, systematic risk is a small proportion of the total risk of the stock. Capital market theory says that the equilibrium return on this stock may be less than that of a stock with much less firm-specific risk but more sensitivity to the factors that drive the return of the overall market. An established manufacturer of machine tools may not be a very risky investment in terms of total risk, Page 166 ©20 15 Kaplan, Inc. Cross-Reference Study Session 12 to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II but may have a greater sensitivity to market (systematic) risk factors (e.g., GDP growth rates) than our biotech stock. Given this scenario, the stock with more total risk (the biotech stock) has less systematic risk and will therefore have a lower equilibrium rate of return according to capital market theory. Note that holding many biotech firms in a portfolio will diversify away the firm-specific risk. Some will have blockbuster products and some will fail, but you can imagine that when 50 or 100 such stocks are combined into a portfolio, the uncertainty about the portfolio return is much less than the uncertainty about the return of a single biotech firm stock. To sum up, unsystematic risk is not compensated in equilibrium because it can be eliminated for free through diversification. Systematic risk is measured by the contribution of a security to the risk of a well-diversified portfolio, and the expected equilibrium return (required return) on an individual security will depend only on its systematic risk. LOS 44.d: Explain return generating models (including the market model) and their uses. usrpomligfecaVPCA CPA ® Program Curriculum, Volume 4, page 404 Return generating models are used to estimate the expected returns on risky securities based on specific factors. For each security, we must estimate the sensitivity of its returns to each specific factor. Factors that explain security returns can be classified as macroeconomic, fundamental, and statistical factors. Multifactor models most commonly use macroeconomic factors such as GDP growth, inflation, or consumer confidence, along with fundamental factors such as earnings, earnings growth, firm size, and research expenditures. Statistical factors often have no basis in finance theory and are suspect in that they may represent only relations for a specific time period which have been identified by data mining (repeated tests on a single data set). The general form of a multifactor model with k factors is as follows: ki E(Ri) - Rf;:; mlkif ~il x E(Factor 1) + ~i2x E(Factor 2) + .... + ~ikx E(Factor k) This model states that the expected excess return (above the risk-free rate) for Asset i is the sum of each factor sensitivity or factor loading (the f3s) for Asset i multiplied by the expected value of that factor for the period. The first factor is often the expected excess return on the market, E(Rm - Rf). One multifactor model that is often used is that of Fama and French. They estimated the sensitivity of security returns to three factors: firm size, firm book value to market value ratio, and the return on the market portfolio minus the risk-free rate (excess return on the market portfolio). Carhart suggests a fourth factor that measures price momentum using prior period returns. Together, these four factors do a relatively good job of explaining returns differences for u.S. equity securities over the period for which the model has been estimated. ©20 15 Kaplan, Inc. Page 167 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II The simplest factor model is a single-factor model. A single-factor model with the return on the market, Rm, as its only risk factor can be written (in excess returns form) as: Here, the expected excess return (return above the risk-free rate) is the product of the factor weight or factor sensitivity, Beta i, and the risk factor, which in this model is the excess return on the market portfolio or market index, so that this is also sometimes called a single-index model. A simplified form of a single-index model is the market model, which is used to estimate a security's (or portfolio's) beta and to estimate a security's abnormal return (return above its expected return) based on the actual market return. The form of the market model is as follows: omieVROC R.1 = 0'.. 1 + A.. R m 1-'1 + e.1 where: R, Return on Asset i ~ = 11arket return ~i = Slope coefficient O'.i = Intercept e. = Abnormal return on Asset i 1 = i The intercept O'.iand slope coefficient ~i are estimated from historical return data. We can require that O'.iis the risk-free rate times (1 - ~i) to be consistent with the general form of a single-index model in excess returns form. The expected return on Asset i is O'.i+ ~iE(Rm). A deviation from the expected return in a given period is the abnormal return on Asset i, e., or R, - (o, + ~iRm). In the market model, the factor sensitivity or beta for Asset i is a measure of how sensitive the return on Asset i is to the return on the overall market portfolio (market index). LOS 44.e: Calculate and interpret beta. usrpomligecaVPCA CPA ® Program Curriculum, Volume 4, page 404 The sensitivity of an asset's return to the return on the market index in the context of the market model is referred to as its beta. Beta is a standardized measure of the covariance of the asset's return with the market return. Beta can be calculated as follows: ~.= covariance of Asset i's return with the market return = COVim 1 Page 168 variance of the market return ©2015 Kaplan, Inc. (J'~ Cross-Reference Study Session 12 to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II We can use the definition of the correlation between the returns on Asset i with the returns on the market index: i to get Covim = Pimaiam. Substituting for Covim in the equation for Bi' we can also calculate beta as: yxwutsrqponmlihgfedcbaXSPNCB 13.= Pimaiam = p. 121mma am ai am Example: Calculating an asset's beta The standard deviation of the return on the market index is estimated as 200/0. 1. If Asset XS standard deviation is 300/0 and its correlation of returns with the market index is 0.8, what is Asset Xs beta? Using the formula 13i= Pim a· 1, am 2. we have: 13.= 0.80 0.30 = 1.2. 1 0.20 If the covariance of Asset Xs returns with the returns on the market index is 0.048, what is the beta of Asset A? . h cIA Covim h A 0.048 U slng t e rormu a I-'i = 2 ,we ave I-'i = 2 = 1.2. am 0.2 Professor's Note: Candidates should be prepared to calculate beta in either of the two ways in the example. In practice, we estimate asset betas by regressing returns on the asset on those of the market index. While regression is a Level II concept, for our purposes, you can think of it as a mathematical estimation procedure that fits a line to a data plot. In Figure 5, we represent the excess returns on Asset i as the dependent variable and the excess returns on the market index as the independent variable. The least squares regression line is the line that minimizes the sum of the squared distances of the points plotted from the line (this is what is meant by the line of bestfit). The slope of this line is our estimate of beta. In Figure 6, the line is steeper than 45 degrees, the slope is greater than one, and the asset's estimated beta is greater than one. Our interpretation is that the returns on Asset i are more variable in response to systematic risk factors than is the overall market, which has a beta of one. ©20 15 Kaplan, Inc. Page 169 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Figure 6: Regression of Asset Excess Returns against Market Asset Returns Asset Excess Return Security Characteristic Line • • • (I\-Rf) tmlfJID • • • • • • B.1 = Slope = • COY· 2 lID (Jm • • 0.. • • • • t Market Excess Return (Rm-~) This regression line is referred to as the asset's security characteristic line. Mathematically, the slope of the security characteristic line is Covim which is the same 2 ' formula we used earlier to calculate beta. (J m LOS 44.£: Explain the capital asset pricing model (CAPM), including its assumptions, and the security market line (SML). urpomligecaVPCA CPA ® Program Curriculum, Volume 4, page 411 Given that the only relevant (priced) risk for an individual Asset i is measured by the covariance between the asset's returns and the returns on the market, Covi,mkt' we can plot the relationship between risk and return for individual assets using Covi,mktas our measure of systematic risk. The resulting line, plotted in Figure 7, is one version of what is referred to as the security market line (SML). i Page 170 ©2015 Kaplan, Inc. Cross-Reference Study Session 12 to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: PartI II Figure 7: Security Market Line Security Market Line (SML) E(Rmkt) - - - - - - - - - - - - Market Porfolio ._--- COVrnkt, mkt= (J 2 mkt Systematic Risk (COVi,mkt) The equation of the SML is: E ( Ri ) = RFR + E (R RFR ( rnkt ) - 2 COVi,rnkt ) O"rnkt which can be rearranged and stated as: E(Ri) = COV· 1 k RFR + 2 ,rn t [E(Rrnkt) O"rnkt - RFR] The line described by this last equation is presented in Figure 8, where we let the standardized covariance term, Cov, rnkt 2' , be defined as beta, f3j. jf O"rnkt This is the most common means of describing the SML, and this relation between beta (systematic risk) and expected return is known as the capital asset pricing model (CAPM). ©20 15 Kaplan, Inc. Page 171 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: PartI II Figure 8: The Capital Asset Pricing Model yrifRJE E(R) Securi ry Market Line (SML) E(Rmkt) - - - - - - - - - - - - +----- Market Portfolio Systematic Risk ( ~i) So, we can define beta, ~= COVi,mkt , as a standardized measure of systematic risk. (J2 rnkt Beta measures the relation between a security's excess returns and the excess returns to the market portfolio. Formally, the CAPM is stated as: The CAPM holds that, in equilibrium, the expected return on risky asset E(Rj) is the risk-free rate (Rf) plus a beta-adjusted market risk premium, ~j[E(Rmk() - Rf]. Beta measures systematic (market or covariance) risk. The assumptions • • • • • • • Page 172 of the CAPM are: zyxvutsrponmlkihgedcbaUROHFDC Risk aversion. To accept a greater degree of risk, investors require a higher expected return. Utility maximizing investors. Investors choose the portfolio, based on their individual preferences, with the risk and return combination that maximizes their (expected) utility. Frictionless markets. There are no taxes, transaction costs, or other impediments to trading. One-period horizon. All investors have the same one-period time horizon. Homogeneous expectations. All investors have the same expectations for assets' expected returns, standard deviation of returns, and returns correlations between assets. Divisible assets.All investments are infinitely divisible. Competitive markets. Investors take the market price as given and no investor can influence prices with their trades. ©20 15 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Comparing the CML and the SML It is important to recognize that the CML and SML are very different. Recall the equation of the CML: The CML uses total risk = (J on the x-axis. Hence, only efficient portfolios will plot on the CML. On the other hand, the SML uses beta (systematic risk) on the x-axis. So in a CAPM world, all properly priced securities and portfolios of securities will plot on the SML, as shown in Figure 9. ywutsrponlihfedcaSML Figure 9: Comparing the CML and the SML (a) Capital Market LinetRME E(R) CMLcBA PIv! w/Iv!argin \ ·A B e ~ = 1 -------------------e-----• • •• t c· •• • •aM PM+ T-bills aM (b) Security Market Line E(R) SML E(R M ) .. .. .... .. .... .. .... .... .. .. .. .. Portfolios that are not well diversified (efficient) plot inside the efficient frontier and are represented by risk-return combinations such as points A, B, and C in panel (a) of Figure 9. Individual securities are one example of such inefficient portfolios. According to the CAPM, the expected returns on all portfolios, well diversified or not, are ©20 15 Kaplan, Inc. Page 173 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II determined by their systematic risk. Thus, according to the CAPM, Point A represents a high-beta stock or portfolio, Point B a stock or portfolio with a beta of one, and Point C a low-beta stock or portfolio. We know this because the expected return at Point B is equal to the expected return on the market, and the expected returns at Point A and C are greater and less than the expected return on the market (tangency) portfolio, respectively. Note that a low-beta stock, such as represented by Point C, is not necessarily low-risk when total risk is considered. While its contribution to the risk of a well-diversified portfolio may be low, its risk when held by itself can be considered quite high. A firm whose only activity is developing a new, but as yet unproven, drug may be quite speculative with highly uncertain returns. It may also have quite low systematic risk if the uncertainty about its future returns depends primarily on firm-specific factors. All stocks and portfolios that plot along the line labeled ~ == 1 in Figure 9 have the same expected return as the market portfolio and, thus, according to the CAPM, have the same systematic risk as the market portfolio (i.e., they all have betas of one). All points on the CML (except the tangency point) represent the risk-return characteristics of portfolios formed by either combining the market portfolio with the risk-free asset or borrowing at the risk-free rate in order to invest more than 1000/0 of the portfolio's net value in the risky market portfolio (investing on margin). Point D in Figure 9 represents a portfolio that combines the market portfolio with the risk-free asset, while points above the point of tangency, such as Point E, represent portfolios created by borrowing at the risk-free rate to invest in the market portfolio. Portfolios that do not lie on the CML are not efficient and therefore have risk that will not be rewarded with higher expected returns in equilibrium. According to the CAPM, all securities and portfolios, diversified or not, will plot on the SML in equilibrium. In fact, all stocks and portfolios along the line labeled ~ == 1 in Figure 9, including the market portfolio, will plot at the same point on the SML. They will plot at the point on the SML with beta equal to one and expected return equal to the expected return on the market, regardless of their total risk. LOS 44.g: Calculate and interpret the expected return of an asset using the CAPM. urpomligecaVPFCA CFA® Program Curriculum, Volume 4, page 414 The CAPM is one of the most fundamental concepts in investment theory. The CAPM is an equilibrium model that predicts the expected return on a stock, given the expected return on the market, the stock's beta coefficient, and the risk-free rate. Page 174 ©2015 Kaplan, Inc. Cross-Reference Study Session 12 to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Example: Capital asset pricing model The expected return on the market is 150/0, the risk-free rate is 80/0, and the beta for Stock A is 1.2. Compute the rate of return that would be expected (required) on this stock. Answer: E(RA) BA = 0.08 + 1.2 (0.15 - 0.08) Note: (3A > 1, so E(RA) > E(~kt) = 0.164 wutsrponmlihgfecaVPNKFCA Professor'sNote: Know this calculation! Example: Capital asset pricing model The expected return on the market is 15%, the risk-free rate is 80/0, and the beta for Stock B is 0.8. Compute the rate of return that would be expected (required) on this stock. Answer: E(RB)= 0.08 + 0.8 (0.15 - 0.08) = 0.136 Note: Beta < 1 so E(RB) < E(Rmkt) LOS 44.h: Describe and demonstrate applications of the CAPM and the SML. CFA ® Program Curriculum, Volume 4, page 416 We have used beta to estimate a security's expected return based on our estimate of the risk-free rate and the expected return on the market. In equilibrium, a security's expected return and its required return (by investors) are equal. Therefore, we can use the CAPM to estimate a security's required return, as in the following example. Example: Using beta to estimate a required return Acme, Inc., has a capital structure that is 400/0 debt and 60% equity. The expected return on the market is 120/0, and the risk-free rate is 40/0. What discount rate should an analyst use to calculate the NPV of a project with an equity beta of 0.9 if the firm's after-tax cost of debt is 50/0? Answer: The required return on equity for this project is 0.04 + 0.9(0.12 - 0.04) = 11.20/0. The appropriate discount rate is a weighted average of the costs of debt and equity for this project, 0.4(50/0) + 0.6(11.2%) = 8.720/0. ©20 15 Kaplan, Inc. Page 175 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Because the SML shows the equilibrium (required) return for any security or portfolio based on its beta (systematic risk), analysts often compare their forecast of a security's return to its required return based on its beta risk. The following example illustrates this technique. Example: Identifying mispriced securities The following figure contains information based on analyst's forecasts for three stocks. Assume a risk-free rate of 70/0 and a market return of 150/0. Compute the expected and required return on each stock, determine whether each stock is undervalued, overvalued, or properly valued, and outline an appropriate trading strategy. Forecast Data ywvutsrqponlkiedcbaYTSRPFEDB Stock Price Today E(Price} in 1 Year E(Dividend} in 1 Year Beta A $25 $27 $1.00 1.0 B 40 45 2.00 0.8 C 15 17 0.50IBA 1.2 Answer: Expected and required returns computations are shown in the following figure. Forecasts vs. Required Returns Stock Forecast Return Required Return A ($27 - $25 + $1)I I $25 = 12.0% 0.07 + (1.0)(0.15 - 0.07) = 15.0% B ($45 - $40 + $2) I $40 = 17.50/0 0.07 + (0.8)(0.15 - 0.07) = 13.4% C ($17 - $15 + $0.5) I $15 0.07 + (1.2)(0.15 - 0.07) = 16.6% = 16.60/0 I • • • Stock A isovervalued. It is expected to earn 120/0, but based on its systematic risk, it should earn 150/0. It plots below the SML. Stock B isundervalued. It is expected to earn 17.5%, but based on its systematic risk, it should earn 13.40/0. It plots above the SML. Stock C isproperly valued. It is expected to earn 16.60/0, and based on its systematic risk, it should earn 16.60/0. It plots on the SML. The appropriate trading strategy is: • • • Short sell Stock A. Buy Stock B. Buy, sell, or ignore Stock C. We can do this same analysis graphically. The expected return/beta combinations of all three stocks are graphed in the following figure relative to the SML. Page 176 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Identifying Mispriced Securities fRECB E(R) B • SML C • 7 beta risk 0.8 Professor's Note: "under" valued. "over" valued. 1.2yxvutsrponmlkihfedcaSPNML 1 fI If the estimated If the estimated return plots "over" the SML, the security is return plots "under" the SML, the security is Remember, all stocks should plot on the SML; any stock not plotting on the SML is mispriced. Notice that Stock A falls below the SML, Stock B lies above the SML, and Stock C is on the SML. If you plot a stock's expected return and it falls below the SML, the stock is overpriced. That is, the stock's expected return is too low given its systematic risk. If a stock plots above the SML, it is underpriced and is offering an expected return greater than required for its systematic risk. If it plots on the SML, the stock is properly priced. Because the equation of the SML is the capital asset pricing model, you can determine if a stock is over- or underpriced graphically or mathematically. Your answers will always be the same. When we evaluate the performance of a portfolio with risk that differs from that of a benchmark, we need to adjust the portfolio returns for the risk of the portfolio. There are several measures of risk-adjusted returns that are used to evaluate relative portfolio performance. One such measure is the Sharpe ratio Rp - Rf • <Jp The Sharpe ratio of a portfolio is its excess returns per unit of total portfolio risk, and higher Sharpe ratios indicate better risk-adjusted portfolio performance. Note that this is a slope measure and, as illustrated in Figure 9, the Sharpe ratios of all portfolios along the CML are the same. Because the Sharpe ratio uses total risk, rather than systematic risk, it accounts for any unsystematic risk that the portfolio manager has taken. Note that the value of the Sharpe ratio is only useful for comparison with the Sharpe ratio of another portfolio. ©20 15 Kaplan, Inc. Page 177 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: PartI IIvutsrponihfedcaSQPNMJ Professor'sNote: We introduced the Sharpe ratio in Quantitative Methods. eW In Figure 10, we illustrate that the Sharpe ratio is the slope of the CAL for the portfolio and can be compared to the slope of the CML, which is the Sharpe ratio for any portfolio along the CML. Figure 10: Sharpe Ratios as Slopes E(R) R1)2 - R, CML slope = CAL slope = ---'-'''---------'pfRMJIE CYp2 RI'2 R M -R CYM f Rpl-Rf CYPI P2 • • • • • • • • • • • •I • I I I I I I I I I The M-squared (M2) measure produces the same portfolio rankings as the Sharpe ratio but is stated in percentage terms. It is calculated as (Rp -Rf) (JM -(RM -Rf). (Jp The intuition of this measure is that the first term is the excess return on a Portfolio P*, constructed by taking a leveraged position in Portfolio P so that P* has the same total risk, (J M' as the market portfolio. As shown in Figure 11, the excess return on such a leveraged portfolio is greater than the return on the market portfolio by the vertical distance M2. Page 178 ©20 15 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: PartPI II Figure 11: M-squared for a PortfolioRE E(R) - - - - - - - - - - - - - - - - - - - . P*pfRMJIE I I I~ I I I I I I --------- :M I I I I I I I I I I I (J (Jp (JM Two measures of risk-adjusted returns based on systematic risk are the Treynor measure and Jensen's alpha. They are and M2 in that the Treynor measure is based on slope and percentage returns in excess of those from a portfolio that the SML. The Treynor measure is calculated as Rp - Rf ~--~ risk (beta) rather than total similar to the Sharpe ratio Jensen's alpha is a measure of has the same beta but lies on , interpreted as excess returns per ~p unit of systematic risk, and represented by the slope of a line as illustrated in Figure 12. Jensen's alpha for Portfolio P is calculated as ap= Rp - [R, + ~P(RM - Rf)] and is the percentage portfolio return above that of a portfolio (or security) with the same beta as the portfolio that lies on the SML, as illustrated in Figure 12. Figure 12: Treynor Measure and Jensen's Alpha E(R) slope = Treynor measure for Portfolio P SML R, _ Jensen's alpha n, ~p 1 Whether risk adjustment should be based on total risk or systematic risk depends on whether a fund bears the nonsystematic risk of a manager's portfolio. If a single manager is used, then the total risk (including any nonsystematic risk) is the relevant measure and ©20 15 Kaplan, Inc. Page 179 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II risk adjustment using total risk, as with the Sharpe and M2 measures, is appropriate. If a fund uses multiple managers so that the overall fund portfolio is well diversified (has no nonsystematic risk), then performance measures based on systematic (beta) risk, such as the Treynor measure and Jensen's alpha, are appropriate. These measures of risk-adjusted returns are often used to compare the performance of actively managed funds to passively managed funds. Note in Figures 10 and 11 that portfolios that lie above the CML have Sharpe ratios greater than those of any portfolios along the CML and have positive M2 measures. Similarly, in Figure 12, we can see that portfolios that lie above the SML have Treynor measures greater than those of any security or portfolio that lies along the SML and also have positive values for Jensen's alpha. One final note of caution is that estimating the values needed to apply these theoretical models and performance measures is often difficult and is done with error. The expected return on the market, and thus the market risk premium, may not be equal to its average historical value. Estimating security and portfolio betas is done with error as well. Page 180 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II LOS 44.a The availability of a risk-free asset allows investors to build portfolios with superior risk-return properties. By combining a risk-free asset with a portfolio of risky assets, the overall risk and return can be adjusted to appeal to investors with various degrees of risk rpnmiRA • aversion. LOS 44.h On a graph of return versus risk, the various combinations of a risky asset and the riskfree asset form the capital allocation line (CAL). In the specific case where the risky asset is the market portfolio, the combinations of the risky asset and the risk-free asset form the capital market line (CML). LOS 44.c Systematic (market) risk is due to factors, such as GDP growth and interest rate changes, that affect the values of all risky securities. Systematic risk cannot be reduced by diversification. Unsystematic (firm-specific) risk can be reduced by portfolio diversification. Because one of the assumptions underlying the CAPM is that portfolio diversification to eliminate unsystematic risk is costless, investors cannot increase expected equilibrium portfolio returns by taking on unsystematic risk. LOS 44.d A return generating model is an equation that estimates the expected return of an investment, based on a security's exposure to one or more macroeconomic, fundamental, or statistical factors. The simplest return generating model is the market model, which assumes the return on an asset is related to the return on the market portfolio in the following manner: R.1 == a.1 + A.R + e.1 1-'1 m LOS 44.e Beta can be calculated using the following equation: A. 1-'1 = [Cov(Ri,Rm)] = Pi,mai 2ma am am where [Cov(Ri,Rm)] and p.r.rn are the covariance and correlation between the asset and the market, and a i and am are the standard deviations of asset returns and market returns. a The theoretical average beta of stocks in the market is 1. A beta of zero indicates that a security's return is uncorrelated with the returns of the market. ©20 15 Kaplan, Inc. Page 181 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II LOS 44.f The • • • • • • capital asset pricing model (CAPM) requires several assumptions: Investors are risk averse, utility maximizing, and rational. Markets are free of frictions like costs and taxes. All investors plan using the same time period. All investors have the same expectations of security returns. Investments are infinitely divisible. Prices are unaffected by an investor's trades. The security market line (SML) is a graphical representation of the CAPM that plots expected return versus beta for any security. LOS 44.g The CAPM relates expected return to the market factor (beta) using the following formula: LOS 44.h The CAPM and the SML indicate what a security's equilibrium required rate of return should be based on the security's exposure to market risk. An analyst can compare his expected rate of return on a security to the required rate of return indicated by the SML to determine whether the security is overvalued, undervalued, or properly valued. The Sharpe ratio measures excess return per unit of total risk and is useful for comparing portfolios on a risk-adjusted basis. The M-squared measure provides the same portfolio rankings as the Sharpe ratio but is stated in percentage terms: Sharpe ratio Rp - Rf «pfRM O"p Mvsquared « O"M (Rp-Rf) -(RM -Rf) O"p The Treynor measure measures a portfolio's excess return per unit of systematic risk. Jensen's alpha is the difference between a portfolio's return and the return of a portfolio on the SML that has the same beta: Treynor measure ;:; Rp- Rf ~p Page 182 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II 1. nA An investor put 600/0 of his portfolio into a risky asset offering a 100/0 return with a standard deviation of returns of 80/0 and put the balance of his portfolio in a risk-free asset offering 50/0. What is the expected return and standard deviation of his portfolio? Expected return Standard deviation A. 6.00/0 6.80/0 B. 8.00/0 4.80/0 C. 10.00/0 6.60/0 2. What is the risk measure associated with the capital market line (CML)? A. Beta risk. B. Unsystematic risk. C. Total risk. 3. A portfolio to the right of the market portfolio on the CML is: A. a lending portfolio. B. a borrowing portfolio. C. an inefficient portfolio. 4. As A. B. C. 5. Total risk equals: A. unique plus diversifiable risk. B. market plus nondiversifiable risk. C. systematic plus unsystematic risk. 6. A return generating model is least likely to be based on a security's exposure to: A. statistical factors. B. macroeconomic factors. C. fundamental factors. 7. The covariance of the market's returns with a stock's returns is 0.005 and the standard deviation of the market's returns is 0.05. What is the stock's beta? A. 1.0. B. 1.5. C. 2.0. 8. The covariance of the market's returns with the stock's returns is 0.008. The standard deviation of the market's returns is 0.08, and the standard deviation of the stock's returns is 0.11. What is the correlation coefficient of the returns of the stock and the returns of the market? A. 0.91. B. 1.00. C. 1.25. the number of stocks in a portfolio increases, the portfolio's systematic risk: can increase or decrease. decreases at a decreasing rate. decreases at an increasing rate. ytslkiea ©20 15 Kaplan, Inc. Page 183 Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II Page 184 9. According to the CAPM, what is the expected rate of return for a stock with a beta of 1.2, when the risk-free rate is 60/0 and the market rate of return is 120/0? A. 7.20/0. B. 12.00/0. C. 13.20/0. 10. According to the CAPM, what is the required rate of return for a stock with a beta of 0.7, when the risk-free rate is 70/0 and the expected market rate of return is 140/0? A. 11.90/0. B. 14.00/0. C. 16.80/0. 11. The risk-free rate is 60/0, and the expected market return is 15%. A stock with a beta of 1.2 is selling for $25 and will pay a $1 dividend at the end of the year. If the stock is priced at $30 at year-end, it is: A. overpriced, so short it. B. underpriced, so buy it. C. underpriced, so short it. 12. A stock with a beta of 0.7 currently priced at $50 is expected to increase in price to $55 by year-end and pay a $1 dividend. The expected market return is 15%, and the risk-free rate is 80/0. The stock is: A. overpriced, so do not buy it. B. underpriced, so buy it. C. properly priced, so buy it. 13. Which of the following statements about the SML and the CML is least accurate? A. Securities that plot above the SML are undervalued. B. Investors expect to be compensated for systematic risk. C. Securities that plot on the SML have no value to investors. utsrleca ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #44 - Portfolio Risk and Return: Part II 1. B Expected return: (0.60 x 0.10)CA + (0.40 x 0.05) Standard deviation: 0.60 x 0.08 = = 0.08, or 8.0%. 0.048, or 4.8%. 2. C The capital market line (CML) plots return againstywvutsrponmlkiedcba total risk which is measured by standard deviation of returns. 3. B A portfolio to the right of a portfolio on the CML has more risk than the market portfolio. Investors seeking to take on more risk will borrow at the risk-free rate to purchase more of the market portfolio. 4. A When you increase the number of stocks in a portfolio, unsystematic risk will decrease at a decreasing rate. However, the portfolio's systematic risk can be increased by adding higher-beta stocks or decreased by adding lower-beta stocks. 5. C Total risk equals systematic plus unsystematic risk. Unique risk is diversifiable and is unsystematic. Market (systematic) risk is nondiversifiable risk. 6 A Macroeconomic, return generating statistical factors and fundamental 7. C Beta = covariance / market variance Market variance Beta = fundamental, and statistical factor exposures can be included in a model to estimate the expected return of an investment. However, may not have any theoretical basis, so analysts prefer macroeconomic factor models. = 0.052 0.005 / 0.0025 = = 0.0025 2.0 0.008 = 0.909 (0.08)(0.11) 8. A 9. C 6 + 1.2(12 - 6) = 13.20/0 10. A 7 + 0.7(14 - 7) = 11.90/0 11. B Required rate 6 + = Return on stock = 1.2(15 - 6) (30 - 25 + = 16.8% 1) / 25 = 240/0 Based on risk, the stock plots above the SML and is underpriced, so buy it. 12. A Required rate = Return on stock 8 = + 0.7(15 - 8) = 12.9% (55 - 50 + 1) / 50 = 120/0 The stock falls below the SML so it is overpriced. 13. C Securities that plot on the SML are expected to earn their equilibrium rate of return and, therefore, do have value to an investor and may have diversification benefits as well. The other statements are true. ©20 15 Kaplan, Inc. Page 185 The following is a review of the Portfolio Management principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #45.UTSRPONLIGFDCBA BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION Study Session 12XMEA EXAM Focus There is nothing difficult here, but the material is important because it is the foundation for the portfolio construction material at Level II and especially Level III. You should be ready to explain why investment policy statements are created and what their major components are. You should be familiar with the objectives (risk and return) and the constraints: liquidity, legal, time horizon, tax treatment, and unique circumstances. Know the difference between ability and willingness to take risk, the factors that define an asset class, and how asset allocation is used in constructing portfolios. LOS 45.a: Describe the reasons for a written investment policy statement (IPS). vutsrponmljihgfedcbaVSRPOIGDCA CPA ® Program Curriculum, Volume 4, page 442 An investment manager is very unlikely to produce a good result for a client without understanding that client's needs, circumstances, and constraints. A written investment policy statement will typically begin with the investor's goals in terms of risk and return. These should be determined jointly, as the goals of high returns and low risk (while quite popular) are likely to be mutually exclusive in practice. Investor expectations in terms of returns must be compatible with investor's tolerance for risk (uncertainty about portfolio performance). LOS 45.b: Describe the major components of an IPS. CPA ® Program Curriculum, Volume 4, page 443 The major components of an IPS typically address the following: • • • • • • • Page 186 Description of Client circumstances, situation, and investment objectives. Statement of the Purpose of the IPS. Statement of Duties and Responsibilities of investment manager, custodian of assets, and the client. Proceduresto update IPS and to respond to various possible situations. Investment Objectives derived from communications with the client. Investment Constraints that must be considered in the plan. Investment Guidelines such as how the policy will be executed, asset types permitted, and leverage to be used. ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and ConstructionvutsrponmligfedcbaVP • • Evaluation of Performance, the benchmark portfolio for evaluating investment performance, and other information on evaluation of investment results. Appendices containing information on strategic (baseline) asset allocation and permitted deviations from policy portfolio allocations, as well as how and when the portfolio allocations should be rebalanced. In any case, the IPS will, at a minimum, contain a clear statement of client circumstances and constraints, an investment strategy based on these, and some benchmark against which to evaluate the account performance. LOS 45.c: Describe risk and return objectives and how they may be developed for a client. CPA ® Program Curriculum, Volume 4, page 444 The risk objectives in an IPS may take several forms. An absolute risk objective might be to "have no decrease in portfolio value during any 12-month period" or to "not decrease in value by more than 20/0at any point over any 12-month period." Low absolute percentage risk objectives such as these may result in portfolios made up of securities that offer guaranteed returns (e.g., u.S. Treasury bills). Absolute risk objectives can also be stated in terms of the probability of specific portfolio results, either percentage losses or dollar losses, rather than strict limits on portfolio results. Examples are as follows: • • "No greater than a 50/0probability of returns below -50/0 ni any 12-month period." "No greater than a 40/0probability of a loss of more than $20,000 over any 12-month period." An absolute return objective may be stated in nominal terms, such as "an overall return of at least 60/0per annum," or in real returns, such as "a return of 30/0more than the annual inflation rate each year." Relative risk objectives relate to a specific benchmark and can also be strict, such as, "Returns will not be less than 12-month euro LIBOR over any 12-month period," or stated in terms of probability, such as, "No greater than a 50/0probability of returns more than 40/0below the return on the MSCI World Index over any 12-month period." Return objectives can be relative to a benchmark portfolio return, such as, "Exceed the return on the S&P 500 Index by 20/0per annum." For a bank, the return objective may be relative to the bank's cost of funds (deposit rate). While it is possible for an institution to use returns on peer portfolios, such as an endowment with a stated objective to be in the top quartile of endowment fund returns, peer performance benchmarks suffer from not being investable portfolios. There is no way to match this investment return by portfolio construction before the fact. In any event, the account manager must make sure that the stated risk and return objectives are compatible, given the reality of expected investment results and • • uncertainty over time. ©20 15 Kaplan, Inc. Page 187 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and Construction LOS 45.d: Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor's financial risk tolerance. zyxwvutsrqponmlkihgfedcaWVUTSRPNLIFCA CFA® Program Curriculum, Volume 4, page 445 An investor's ability to bear risk depends on financial circumstances. Longer investment horizons (20 years rather than 2 years), greater assets versus liabilities (more wealth), more insurance against unexpected occurrences, and a secure job all suggest a greater ability to bear investment risk in terms of uncertainty about periodic investment performance. An investor's willingness to bear risk is based primarily on the investor's attitudes and beliefs about investments (various asset types). The assessment of an investor's attitude about risk is quite subjective and is sometimes done with a short questionnaire that attempts to categorize the investor's risk aversion or risk tolerance. When the adviser's assessments of an investor's ability and willingness to take investment risk are compatible, there is no real problem selecting an appropriate level of investment risk. If the investor's willingness to take on investment risk is high but the investor's ability to take on risk is low, the low ability to take on investment risk will prevail in the adviser's assessment. In situations where ability is high but willingness is low, the adviser may attempt to educate the investor about investment risk and correct any misconceptions that may be contributing to the investor's low stated willingness to take on investment risk. However, the adviser's job is not to change the investor's personality characteristics that contribute to a low willingness to take on investment risk. The approach will most likely be to conform to the lower of the investor's ability or willingness to bear risk, as constructing a portfolio with a level of risk that the client is clearly uncomfortable with will not likely lead to a good outcome in the investor's view. LOS 45.e: Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets. CFA® Program Curriculum, Volume 4, page 450 Professor's Note: When I was studying for the CFA exams over 20 years ago, we memorized R-R- T- T-L-L-U as a checklist for addressing the important points of portfolio construction, and it still works today. Then, as now, the important points to cover in an IPS were Risk, Return, Time horizon, Tax situation, Liquidity, Legal restrictions, and the Unique constraints of a specific investor. Investment constraints include the investor's liquidity needs, time horizon, tax considerations, legal and regulatory constraints, and unique needs and preferences. Page 188 ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and Construction Liquidity: Liquidity refers to the ability to turn investment assets into spendable cash in a short period of time without having to make significant price concessions to do so. Investor needs for money to pay tuition, to pay for a parent's assisted living expenses, or to fund other possible spending needs may all require that some liquid assets be held. As we noted in an earlier topic review discussing property and casualty insurance companies, claims arrive unpredictably to some extent and therefore their portfolios must hold a significant proportion of liquid (or maturing) securities in order to be prepared to honor these claims. Illiquid investments in hedge funds and private equity funds, which typically are not traded and have restrictions on redemptions, are not suitable for an investor who may unexpectedly need access to the funds. Time horizon: In general, the longer an investor's time horizon, the more risk and less liquidity the investor can accept in the portfolio. While the expected returns on a broad equities portfolio may not be too risky for an investor with a 20-year investment horizon, they likely are too risky for an investor who must fund a large purchase at the end of this year. For such an investor, government securities or a bank certificate of deposit may be the most appropriate investments because of their low risk and high liquidity at the time when the funds will be needed. Tax:situation: Besides an individual's overall tax rate, the tax treatment of various types of investment accounts is also a consideration in portfolio construction. For a fully taxable account, investors subject to higher tax rates may prefer tax-free bonds (U.S.) to taxable bonds or prefer equities that are expected to produce capital gains, which are often taxed at a lower rate than other types of income. A focus on expected aftertax returns over time in relation to risk should correctly account for differences in tax treatments as well as investors' overall tax rates. Some types of investment accounts, such as retirement accounts, may be tax exempt or tax deferred. Investors with such accounts may choose to put securities that generate fully taxed income, such as corporate bond interest, in accounts that are tax deferred, while seeking long-term capital gains, tax-exempt interest income, and dividend income (in jurisdictions where dividends receive preferential tax treatment) in their personal accounts, which have no tax deferral benefit. Legal and regulatory: In addition to financial market regulations that apply to all investors, more specific legal and regulatory constraints may apply to particular investors. Trust, corporate, and qualified investment accounts may all be restricted by law from investing in particular types of securities and assets. There may also be restrictions on percentage allocations to specific types of investments in such accounts. Corporate officers and directors face legal restrictions on trading in the securities of their firms that the account manager should be aware of. Unique circumstances: Each investor, whether individual or institutional, may have specific preferences or restrictions on which securities and assets may be purchased for the account. Ethical preferences, such as prohibiting investment in securities issued by tobacco or firearms producers, are not uncommon. Restrictions on investments in companies or countries where human rights abuses are suspected or documented would also fall into this category. Religious preferences may preclude investment in securities that make explicit interest payments. Unique investor preferences may also be based on diversification needs when the investor's income depends heavily on the prospects for ©20 15 Kaplan, Inc. Page 189 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and Construction one company or industry. An investor who has founded or runs a company may not want any investment in securities issued by a competitor to that company. LOS 45.f: Explain the specification of asset classes in relation to asset allocation. wutrponmlihgecbaVSPFCA CFA® Program Curriculum, Volume 4, page 458 After having determined the investor objectives and constraints through the exercise of creating an IPS, a strategic asset allocation is developed which specifies the percentage allocations to the included asset classes. In choosing which asset classes to consider when developing the strategic asset allocation for the account, the correlations of returns within an asset class should be relatively high, indicating that the assets within the class are similar in their investment performance. On the other hand, it is low correlations of returns between asset classes that leads to risk reduction through portfolio diversification. Historically, only the broad categories of equities, bonds, cash, and real estate were considered. More recently, a group of several investable asset classes, referred to collectively as alternative investments, has gained more prominence. Alternative investment asset classes include hedge funds of various types, private equity funds, managed or passively constructed commodity funds, artwork, and intellectual property rights. We can further divide equities by whether the issuing companies are domestic or foreign, large or small, or whether they are traded in emerging or developed markets. An example of specifying asset classes is world equities. A U.S. investor may want to divide world equities into different regions. Figure 1 shows the correlation matrix, annualized returns, and volatilities among four different regions and the United States. Figure 1: World Equities Asset Class Correlation Matrix Monthly Index Returns from MSCI Price Returns 10 Year Period from June 28, 2001, to June 29, 2012 1 2 3 5 1. MSCI USA 1.00 2. MSCI Emerging Markets Europe 0.74 1.00 3. MSCI Emerging Markets Asia 0.79 0.80 1.00 4. MSCI Emerging Markets Latin America 0.79 0.85 0.82 1.00 5. MSCI Frontier Markets Africa 0.35 0.41 0.33 0.34 1.00 Annualized Volatility 15.860/0 32.52% 24.54% 28.650/0 27.470/0 Annualized Return 3.440/0 11.20% 9.31% 17.010/0 9.330/0 Source: www.msci.com/products/indices/ Page 190 4 ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and Construction With bonds, we can divide the overall universe of bonds into asset classes based on maturities or on criteria such as whether they are foreign or domestic, government or corporate, or investment grade or speculative (high yield). Overall, the asset classes considered should approximate the universe of permissible investments specified in the IPS. Once the universe of asset classes has been specified, the investment manager will collect data on the returns, standard deviation of returns, and correlations of returns with those of other asset classes for each asset class. Figure 2 illustrates the strategic asset allocation for a pension fund. Figure 2: Strategic Asset Allocation The Vermont Pension Investment Committee manages about $3 billion in retirement assets for various teachers and state and municipal employees in that state. VPIC's investment policy specifies the following strategic asset allocation: utsrponmligfecaVTPFCA Asset Class Target 0.00/0 Cash u.s. large-cap 11.00/0 equity U.S. small-/mid-cap equity Established international equity Emerging market equity 6.50/0 10.00/0 6.00/0 18.00/0 U.S. bonds Global bonds 3.00/0 High-yield bonds 6.00/0 Emerging market debt 5.00/0 Inflation-protected 3.00/0 bonds Real estate 4.50/0 Hedge funds 5.00/0 Private equity 0.00/0 Commodities 2.00/0 Global asset allocation and other 20.00/0 1000/0 Source: State of Vermont, Office of the State Treasurer. Target allocation as of March 31, 2012. www.vermonttreasurer.gov/pension-funds. LOS 45.g: Describe the principles of portfolio construction and the role of asset allocation in relation to the IPS. CFA® Program Curriculum, Volume 4, page 458 Once the portfolio manager has identified the investable asset classes for the portfolio and the risk, return, and correlation characteristics of each asset class, an efficient frontier, ©20 15 Kaplan, Inc. Page 191 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and Construction analogous to one constructed from individual securities, can be constructed using a computer program. By combining the return and risk objectives from the IPS with the actual risk and return properties of the many portfolios along the efficient frontier, the manager can identify that portfolio which best meets the risk and return requirements of the investor. The asset allocation for the efficient portfolio selected is then the strategic asset allocation for the portfolio. So far, we have not concerned ourselves with deviations from strategic asset allocations or with selection of individual securities within individual asset classes. These activities are referred to as active (versus passive) portfolio management strategies. A manager who varies from strategic asset allocation weights in order to take advantage of perceived short-term opportunities is adding tactical asset allocation to the portfolio strategy. Security selection refers to deviations from index weights on individual securities within an asset class. For example, a portfolio manager might overweight energy stocks and underweight financial stocks, relative to the index weights for u.S. large-cap equities as an asset class. For some asset classes, such as hedge funds, individual real estate properties, and artwork, investable indexes are not available. For these asset classes, selection of individual assets is required by the nature of the asset class. While each of these active strategies may produce higher returns, they each also increase the risk of the portfolio compared to a passive portfolio of asset class indexes. A practice known as risk budgeting sets an overall risk limit for the portfolio and budgets (allocates) a portion of the permitted risk to the systematic risk of the strategic asset allocation, the risk from tactical asset allocation, and the risk from security selection. Active portfolio management has two specific issues to consider. 1. An investor may have multiple managers actively managing to the same benchmark for the same asset class (or may have significant benchmark overlap). In this case, one manager may overweight an index stock while another may underweight the same stock. Taken together, there is no net active management risk, although each manager has reported active management risk. Overall, the risk budget is underutilized as there is less net active management than gross active management. 2. When all managers are actively managing portfolios relative to an index, trading may be excessive overall. This extra trading could have negative tax consequences, specifically potentially higher capital gains taxes, compared to an overall efficient tax strategy. One way to address these issues is to use a core-satellite approach. The core-satellite approach invests the majority, or core, portion of the portfolio in passively managed indexes and invests a smaller, or satellite, portion in active strategies. This approach reduces the likelihood of excessive trading and offsetting active positions. Clearly, the success of security selection will depend on the manager's skill and the opportunities (mispricings or inefficiencies) within a particular asset class. Similarly, the success of tactical asset allocation will depend both on the existence of short-term opportunities in specific asset classes and on the manager's ability to identify them. Page 192 ©2015 Kaplan, Inc. Study Session 12 Cross- Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and Construction LOS 45.a A written investment policy statement, the first step in the portfolio management process, is a plan for achieving investment success. An IPS forces investment discipline and ensures that goals are realistic by requiring investors to articulate their circumstances, objectives, and constraints. nA LOS 45.h Many IPS include the following sections: • Introduction-Describes the client. • Statement of Purpose-The intentions of the IPS. • Statement of Duties and Responsibilities-Of the client, ht e asset custodian, and the • Investment managers. • Procedures-Related to keeping the IPS updated and responding to unforeseen events. • Investment Objectives-The client's investment needs, specified in terms of required return and risk tolerance. • Investment Constraints-Factors that may hinder the ability to meet investment objectives; typically categorized as time horizon, taxes, liquidity, legal and regulatory, and unique needs. • Investment Guidelines-For example, whether leverage, derivatives, or specific kinds of assets are allowed. • Evaluation and Review-Related to feedback on investment er sults. • Appendices-May specify the portfolio's strategic asset allocation (policy portfolio) or the portfolio's rebalancing policy. LOS 45.c Risk objectives are specifications for portfolio risk that are developed to embody a client's risk tolerance. Risk objectives can be either absolute (e.g., no losses greater than 100/0in any year) or relative (e.g., annual return will be within 20/0ofFTSE return). Return objectives are typically based on an investor's desire to meet a future financial goal, such as a particular level of income in retirement. Return objectives can be absolute (e.g., 90/0annual return) or relative (e.g., outperform the S&P 500 by 20/0per year). The achievability of an investor's return expectations may be hindered by the investor's risk objectives. LOS 45.d Willingness to take financial risk is related to an investor's psychological factors, such as personality type and level of financial knowledge. Ability or capacity to take risk depends on financial factors, such as wealth relative to liabilities, income stability, and time horizon. A client's overall risk tolerance depends on both his ability to take risk and his willingness to take risk. A willingness greater than ability, or vice versa, is typically resolved by choosing the more conservative of the two and counseling the client. ©20 15 Kaplan, Inc. Page 193 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and Construction LOS 45.e Investment constraints include: • Liquidity-The need to draw cash from the portfolio for anticipated or unexpected future spending needs. High liquidity needs often translate to a high portfolio allocation to bonds or cash. • Time horizon-Often the period over which assets are accumulated and before withdrawals begin. Risky or illiquid investments may be inappropriate for an investor with a short time horizon. • Tax considerations-Concerns the tax treatments of the investor's various accounts, the relative tax treatment of capital gains and income, and the investor's marginal tax bracket. • Legal and regulatory-Constraints such as government restrictions on portfolio contents or laws against insider trading. • Unique circumstances-Restrictions due to investor preferences (religious, ethical, etc.) or other factors not already considered. LOS 45.f An asset class is a group of securities with similar risk and performance characteristics. Examples of major asset classes include equity, fixed income, cash, and real estate. Portfolio managers also use more narrowly defined asset classes, such as large-cap U.S. equities or speculative international bonds, and alternative asset classes, such as commodities or investments in hedge funds. LOS 45.g Strategic asset allocation is a set of percentage allocations to various asset classes that is designed to meet the investor's objectives. The strategic asset allocation is developed by combining the objectives and constraints in the IPS with the performance expectations of the various asset classes. The strategic asset allocation provides the basic structure of a portfolio. Tactical asset allocation refers to an allocation that deviates from the baseline (strategic) allocation in order to profit from a forecast of shorter-term opportunities in specific asset classes. Page 194 ©2015 Kaplan, Inc. Study Session 12 Cross-Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and Construction 1. The investment policy statement is most accurately considered the: A. starting point of the portfolio management process. B. key intermediate step in the portfolio management process. c. end product of the portfolio management process. yutsromlkieca c 2. The component of an investment objectives is most likely to include A. the investor's risk tolerance. B. unique needs and preferences C. permitted asset types and use policy statement that defines the investment information about: of the investor. of leverage in the investment account. 3. A client exhibits an above-average willingness to take risk but a below-average ability to take risk. When assigning an overall risk tolerance, the investment adviser is most likely to assess the client's overall risk tolerance as: A. above average. B. average. C. below average. 4. Which of the following is least likely an example of a portfolio constraint? A. Higher tax rate on dividend income than on capital gains. B. Significant spending requirements in the near future. C. Minimum total return requirement of 80/0. 5. In determining the appropriate asset allocation for a client's investment account, the manager should: A. consider only the investor's risk tolerance. B. incorporate forecasts of future economic conditions. C. consider the investor's risk tolerance and future needs, but not forecasts of market conditions. ©20 15 Kaplan, Inc. Page 195 Study Session 12 Cross- Reference to CFA Institute Assigned Reading #45 - Basics of Portfolio Planning and Construction Page 196 1. AnA An investment policy statement is considered to be the starting point of the portfolio management process. The IPS is a plan for achieving investment success. 2. A Investment objectives are defined based on both the investor's return requirements and risk tolerance. Investment constraints include the investor's time horizon, liquidity needs, tax considerations, legal and regulatory requirements, and unique needs and preferences. Policies regarding permitted asset types and the amount of leverage to use are best characterized as investment guidelines. 3. C When assigning an overall risk tolerance, the prudent approach is to use the lower of ability to take risk and willingness to take risk. 4. C Return objectives are part of a policy statement's objectives, not constraints. 5. B An adviser's forecasts of the expected returns and expected volatilities (risk) of different asset classes are an important part of determining an appropriate asset allocation. ©2015 Kaplan, Inc. 8 questions: 12 minutes utsqonmie yxwvutsrqponmlkjihgfedcbaWTSRPMKICBA 1. Which of the following activities is most likely to be performed as part of the execution step of the portfolio management process? A. Completion of the investment policy statement. B. Top-down analysis based on macroeconomic conditions. C. Rebalancing the portfolio to the desired asset class exposures. 2. A manager who evaluates portfolios' investment performance adjusted for systematic risk is most likely to rank portfolios based on their: A. Sharpe ratios. B. Treynor measures. C. M-squared measures. 3. According to the capital asset pricing model: A. an investor who is risk averse should hold at least some of the risk-free asset in his portfolio. B. a stock with high risk, measured as standard deviation of returns, will have high expected returns in equilibrium. C. all investors who take on risk will hold the same risky-asset portfolio. 4. Beta is best described as the: A. slope of the security market line. B. correlation of returns with those of the market portfolio. C. covariance of returns with the market portfolio expressed in terms of the variance of market returns. 5. Which of the following risk management strategies is most accurately described as shifting a risk? A. A retail store owner buys a fire insurance policy on the building. B. A farmer takes a short position in a futures contract to deliver wheat. C. A portfolio manager diversifies her investments across different industries. yutsromlkiecba ©20 15 Kaplan, Inc. Page 197 Self-Test: Portfolio Management 6. nA An analyst has estimated that the returns for an asset, conditional on the performance of the overall economy, are: ywutsrponmlihecbaRPGE Return Probability Economic Growth 5% 20% Poor 10% 40% Average 14% 40% Good The conditional expected returns on the market portfolio are: Return Probability Economic Growth 2% 20% Poor 10% 40% Average 15% 40% Good According to the CAPM, if the risk-free rate is 50/0 and the risky asset has a beta of 1.1, with respect to the market portfolio, the analyst should: A. sell (or sell short) the risky asset because its expected return is less than equilibrium expected return on the market portfolio. B. buy the risky asset because the analyst expects the return on it to be higher than its required return in equilibrium. C. sell (or sell short) the risky asset because its expected return is not sufficient to compensate for its systematic risk. Page 198 7. Portfolios that plot inside the minimum-variance frontier represent: A. efficient portfolios. B. inefficient portfolios. C. unattainable portfolios. 8. A written investment policy statement should most appropriately: A. establish a target asset allocation strategy. B. focus predominantly on a long-term time horizon. C. ensure that risk objectives are consistent with required returns. ©2015 Kaplan, Inc. Self-Test: Portfolio ManagementsTSRPONMLIGFEA SELF-TEST ANs RS: PORTFOLIO MANAGEMENT 1. B The execution step of the portfolio management process typically begins with a topdown analysis of economic variables. The investment policy statement is completed during the planning step. Asset class rebalancing is part of the feedback step. 2. B The Treynor measure is stated in terms of systematic (beta) risk. The Sharpe ratio and M-squared measure are defined in terms of total risk (standard deviation). 3. C One of the assumptions of the CAPM is that all investors who hold risky assets will hold the same portfolio of risky assets (the market portfolio). Risk aversion means an investor will accept more risk only if compensated with a higher expected return. In capital market theory all investors exhibit risk aversion, even an investor who is short the riskfree asset. In the CAPM, a stock's risk is measured as its beta, not its standard deviation of returns. 4. C A stock or portfolio's beta is its covariance with the returns of the market portfolio divided by the variance of the market portfolio. 5. B Shifting a risk is changing the distribution of possible outcomes. An example of shifting a risk is hedging price risk with a derivatives contract. Insurance is an example of transferring a risk. Diversification is best described as a method for bearing a risk efficiently. 6. C The analyst's forecast of the expected return on the risky asset is 5(0.2) + 10(0.4) + 14(0.4) = 10.60/0.The expected/equilibrium return on the market portfolio is 2(0.2) + 10(0.4) + 15(0.4) = 10.4%. The CAPM equilibrium expected return (required return in equilibrium) on the risky asset is 5 + 1.1(10.4 - 5) = 10.94%. Because the analyst's forecast return on the risky asset is less than its required return in equilibrium, the asset is overpriced and the analyst would sell if he owned it and possibly sell it short. 7. B Portfolios that plot inside the minimum-variance frontier are inefficient because another portfolio exists with a higher expected return for the same level of risk, or a lower level of risk for the same expected return. Portfolios that plot on the minimum-variance frontier above the global minimum-variance portfolio are efficient. Portfolios that plot above the minimum-variance frontier are unattainable. 8. A Strategic asset allocation is often a part of the written IPS because it helps solidify desired initial weightings to specific asset classes. Different investors will have different applicable time horizons which must be considered and evaluated appropriately as part of the investment policy statement. Required returns should be consistent with risk objectives, but return objectives should not determine risk objectives. ©20 15 Kaplan, Inc. Page 199 The following is a review of the Equity: Market Organization, Market Indices, and Market Efficiency principles designed to address the learning outcome statements set forth by CFA Institute. CrossReference to CFA Institute Assigned Reading #46.ZUTSRONMKIGEDCA MARKET ORGANIZATION AND STRUCTURE Study Session 13XMEA EXAM Focus There is a great deal of introductory material in this review. Almost all of the types of securities discussed are covered in detail elsewhere in the curriculum. We introduce the terminology you will need but leave many of the details to the topic reviews specific to each security type. You should understand the concept of purchasing stock on margin and be able to calculate the return on an investment using margin. Be able to differentiate between market and limit orders as well as between quote-driven, order-driven, and brokered markets. Know that market regulation should increase informational, allocational, and operational market efficiency. LOS 46.a: Explain the main functions of the financial system. yvutsrponmlihgfecaVSPFCA CFA® Program Curriculum, Volume 5, page 6 The three main functions of the financial system are to: 1. Allow entities to save and borrow money, raise equity capital, manage risks, trade assets currently or in the future, and trade based on their estimates of asset values. 2. Determine the returns (i.e., interest rates) that equate the total supply of savings with the total demand for borrowing. 3. Allocate capital to its most efficient uses. The financial system allows the transfer of assets and risks from one entity to another as well as across time. Entities who utilize the financial system include individuals, firms, governments, charities, and others. Achievement of Purposes in the Financial System The financial system allows entities to save, borrow, issue equity capital, manage risks, exchange assets, and to utilize information. The financial system is best at fulfilling these roles when the markets are liquid, transactions costs are low, information is readily available, and when regulation ensures the execution of contracts. Savings. Individuals will save (e.g., for retirement) and expect a return that compensates them for risk and the use of their money. Firms save a portion of their sales to fund Page 200 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure future expenditures. Vehicles used for saving include stocks, bonds, certificates of deposit, real assets, and other assets. zyxwutsrqonmlkihgfedcaURIEDB Borrowing. Individuals may borrow in order to buy a house, fund a college education, or for other purposes. A firm may borrow in order to finance capital expenditures and for other activities. Governments may issue debt to fund their expenditures. Lenders can require collateral to protect them in the event of borrower defaults, take an equity position, or investigate the credit risk of the borrower. Issuing equity. Another method of raising capital is to issue equity, where the capital providers will share in any future profits. Investment banks help with issuance, analysts value the equity, and regulators and accountants encourage the dissemination of information. Risk management. Entities face risks from changing interest rates, currency values, commodities values, and defaults on debt, among other things. For example, a firm that owes a foreign currency in 90 days can lock in the price of this foreign currency in domestic currency units by entering into a forward contract. Future delivery of the foreign currency is guaranteed at a domestic-currency price set at inception of the contract. In this transaction, the firm would be referred to as a hedger. This hedging allows the firm to enter a market that it would otherwise be reluctant to enter by reducing the risk of the transaction. Hedging instruments are available from exchanges, investment banks, insurance firms, and other institutions. Exchanging assets. The financial system also allows entities to exchange assets. For example, Proctor and Gamble may sell soap in Europe but have costs denominated in U.S. dollars. Proctor and Gamble can exchange their euros from soap sales for dollars in the currency markets. Utilizing information. Investors with information expect to earn a return on that information in addition to their usual return. Investors who can identify assets that are currently undervalued or overvalued in the market can earn extra returns from investing based on their information (when their analysis is correct). Return Determination The financial system also provides a mechanism to determine the rate of return that equates the amount of borrowing with the amount of lending (saving) in an economy. Low rates of return increase borrowing but reduce saving (increase current consumption). High rates of return increase saving but reduce borrowing. The equilibrium interest rate is the rate at which the amount individuals, businesses, and governments desire to borrow is equal to the amount that individuals, businesses, and governments desire to lend. Equilibrium rates for different types of borrowing and lending will differ due to differences in risk, liquidity, and maturity. ©20 15 Kaplan, Inc. Page 201 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and StructureutrponmligfecaVPFCA Allocation of Capital With limited availability of capital, one of the most important functions of a financial system is to allocate capital to its most efficient uses. Investors weigh the expected risks and returns of different investments to determine their most preferred investments. As long as investors are well informed regarding risk and return and markets function well, this results in an allocation to capital to its most valuable uses. sA LOS 46. b: Describe classifications of assets and markets. CFA® Program Curriculum, Volume 5, page 14 Financial assets include securities (stocks and bonds), derivative contracts, and currencies. Real assets include real estate, equipment, commodities, and other physical assets. Financial securities can be classified as debt or equity. Debt securities are promises to repay borrowed funds. Equity securities represent ownership positions. Public (publicly traded) securities are traded on exchanges or through securities dealers and are subject to regulatory oversight. Securities that are not traded in public markets are referred to as private securities. Private securities are often illiquid and not subject to regulation. Derivative contracts have values that depend on (are derived from) the values of other assets. Financial derivative contracts are based on equities, equity indexes, debt, debt indexes, or other financial contracts. Physical derivative contracts derive their values from the values of physical assets such as gold, oil, and wheat. Markets for immediate delivery are referred to as spot markets. Contracts for the future delivery of physical and financial assets include forwards, futures, and options. Options provide the buyer the right, but not the obligation, to purchase (or sell) assets over some period or at some future date at predetermined prices. The primary market is the market for newly issued securities. Subsequent sales of securities are said to occur in the secondary market. Money markets refer to markets for debt securities with maturities of one year or less. Capital markets refer to markets for longer-term debt securities and equity securities that have no specific maturity date. Traditional investment markets refer to those for debt and equity. Alternative markets refer to those for hedge funds, commodities, real estate, collectibles, gemstones, leases, and equipment. Alternative assets are often more difficult to value, illiquid, require investor due diligence, and therefore often sell at a discount. Page 202 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure LOS 46.c: Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes. vutsrponmlihgfedcbaVPFCA CFA® Program Curriculum, Volume 5, page 16 Assets can be classified as securities, currencies, contracts, commodities, and real assets. Their characteristics and subtypes are as follows. Securities Securities can be classified as fixed income or equity securities, and individual securities can be combined in pooled investment vehicles. Corporations and governments are the most common issuers of individual securities. The initial sale of a security is called an issue when the security is sold to the public. Fixed income securities typically refer to debt securities that are promises to repay borrowed money in the future. Short-term fixed income securities generally have a maturity of less than one or two years; long-term term maturities are longer than five to ten years, and intermediate term maturities fall in the middle of the maturity range. Although the terms are used loosely, bonds are generally long term, whereas notes are intermediate term. Commercial paper refers to short-term debt issued by firms. Governments issue bills and banks issue certificates of deposit. In repurchase agreements, the borrower sells a high-quality asset and has both the right and obligation to repurchase it (at a higher price) in the future. Repurchase agreements can be for terms as short as one day. Convertible debt is debt that an investor can exchange for a specified number of equity shares of the issuing firm. Equity securities represent ownership in a firm and include common stock, preferred stock, and warrants. • • • Common stock is a residual claim on a firm's assets. Common stock dividends are paid only after interest is paid to debtholders and dividends are paid to preferred stockholders. Furthermore, in the event of firm liquidation, debtholders and preferred stockholders have priority over common stockholders and are usually paid in full before common stockholders receive any payment. Preferred stock is an equity security with scheduled dividends that typically do not change over the security's life and must be paid before any dividends on common stock may be paid. Warrants are similar to options in that they give the holder the right to buy a firm's equity shares (usually common stock) at a fixed exercise price prior to the warrant's • • expiration. Pooled investment vehicles include mutual funds, depositories, and hedge funds. The term refers to structures that combine the funds of many investors in a portfolio of ©20 15 Kaplan, Inc. Page 203 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure investments. The investor's ownership interests are referred to as shares, units, depository receipts, or limited partnership interests. yxvutsrponmlkihgfedcbaTSPNMHFEA • • Mutual funds are pooled investment vehicles in which investors can purchase shares, either from the fund itself (open-end funds) or in the secondary market (closed-end funds). Exchange-traded funds (ETFs) and exchange-traded notes E ( TNs) trade like closed-end funds but have special provisions allowing conversion into individual portfolio securities, or exchange of portfolio shares for ETF shares, that keep their market prices close to the value of their proportional interest in the overall portfolio. These funds are sometimes referred to as depositories, with their shares referred to as depository receipts. • • Asset-backed securities represent a claim to a portion of apool of financial assets such as mortgages, car loans, or credit card debt. The return from the assets is passed through to investors, with different classes of claims (referred to as tranches) having different levels of risk. Hedge funds are organized as limited partnerships, with the investors as the limited partners and the fund manager as the general partner. Hedge funds utilize various strategies and purchase is usually restricted to investors of substantial wealth and investment knowledge. Hedge funds often use leverage. Hedge fund managers are compensated based on the amount of assets under management as well as on their investment results. Professor's Note: Asset-backed securities are described in more detail in the Study Session on fixed income. Mutual funds and ETFs are discussed in the Study Session on portfolio management. Hedge funds are discussed in the Study Session on alternative investments. Currencies Currencies are issued by a government's central bank. Some are referred to as reserve currencies, which are those held by governments and central banks worldwide. These include the dollar and euro and, secondarily, the British pound, Japanese yen, and Swiss franc. In spot currency markets, currencies are traded for immediate delivery. Contracts Contracts are agreements between two parties that require some action in the future, such as exchanging an asset for cash. Financial contracts are often based on securities, currencies, commodities, or security indexes (portfolios). They include futures, forwards, options, swaps, and insurance contracts. A forward contract is an agreement to buy or sell an asset in the future at a price specified in the contract at its inception. An agreement to purchase 100 ounces of gold 90 days from now for $1,000 per ounce is a forward contract. Forward contracts are not traded on exchanges or in dealer markets. Futures contracts are similar to forward contracts except that they are standardized as to amount, asset characteristics, and delivery time and are traded on an exchange (in a secondary market) so that they are liquid investments. Page 204 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure In a swap contract, two parties make payments that are equivalent to one asset being traded (swapped) for another. In a simple interest rate swap, floating rate interest payments are exchanged for fixed-rate payments over multiple settlement dates. A currency swap involves a loan in one currency for the loan of another currency for a period of time. An equity swap involves the exchange of the return on an equity index or portfolio for the interest payment on a debt instrument. ywutsrqponmieca nA An option contract gives its owner the right to buy or sell an asset at a specific exercise price at some specified time in the future. A call option gives the option buyer the right (but not the obligation) to buy an asset. A put option gives the option buyer the right (but not the obligation) to sell an asset. Sellers, or writers, of call (put) options receive a payment, referred to as the option premium, when they sell the options but incur the obligation to sell (buy) the asset at the specified price if the option owner chooses to exercise it. Options on currencies, stocks, stock indexes, futures, swaps, and precious metals are traded on exchanges. Customized options contracts are also sold by dealers in the overthe-counter market. An insurance contract pays a cash amount if a future event occurs. They are used to hedge against unfavorable, unexpected events. Examples include life, liability, and automobile insurance contracts. Insurance contracts can sometimes be traded to other parties and often have tax-advantaged payouts. Credit default swaps are a form of insurance that makes a payment if an issuer defaults on its bonds. They can be used by bond investors to hedge default risk. They can also be used by parties that will experience losses if an issuer experiences financial distress and by others who are speculating that the issuer will experience more or less financial trouble than is currently expected. Commodities Commodities trade in spot, forward, and futures markets. They include precious metals, industrial metals, agricultural products, energy products, and credits for carbon reduction. Futures and forwards allow both hedgers and speculators to participate in commodity markets without having to deliver or store the physical commodities. Real Assets Examples of real assets are real estate, equipment, and machinery. Although they have been traditionally held by firms for their use in production, real assets are increasingly held by institutional investors both directly and indirectly. Buying real assets directly often provides income, tax advantages, and diversification benefits. However, they often entail substantial management costs. Furthermore, because ©20 15 Kaplan, Inc. Page 205 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure of their heterogeneity, they usually require the investor to do substantial due diligence before investing. They are illiquid because their specialization may result in a limited pool of investors for a particular real asset. Rather than buying real assets directly, an investor may choose to buy them indirectly through an investment such as a real estate investment trust (REIT) or master limited partnership (MLP). The investor owns an interest in these vehicles, which hold the assets directly. Indirect ownership interests are typically more liquid than ownership of the assets themselves. Another indirect ownership method is to buy the stock of firms that have large ownership of real assets. xvutsrponmlkihgedcaVPFEDCBA LOS 46.d: Describe types of financial intermediaries and services that they provide. CFA® Program Curriculum, Volume 5, page 28 Financial intermediaries stand between buyers and sellers, facilitating the exchange of assets, capital, and risk. Their services allow for greater efficiency and are vital to a well-functioning economy. Financial intermediaries include brokers and exchanges, dealers, securitizers, depository institutions, insurance companies, arbitrageurs, and clearinghouses. Brokers, Dealers, and Exchanges Brokers help their clients buy and sell securities by finding counterparties to trades in a cost efficient manner. They may work for large brokerage firms, for banks, or at exchanges. Block brokers help with the placement of large trades. Typically, large trades are difficult to place without moving the market. For example, a large sell order might cause a security's price to decrease before the order can be fully executed. Block brokers help conceal their clients' intentions so that the market does not move against them. Investment banks help corporations sell common stock, preferred stock, and debt securities to investors. They also provide advice to firms, notably about mergers, acquisitions, and raising capital. Exchanges provide a venue where traders can meet. Exchanges sometimes act as brokers by providing electronic order matching. Exchanges regulate their members and require firms that list on the exchange to provide timely financial disclosures and to promote shareholder democratization. Exchanges acquire their regulatory power through member agreement or from their governments. Alternative trading systems (ATS), which serve the same trading function as exchanges but have no regulatory function, are also known as electronic communication networks (ECNs) or multilateral trading facilities (MTFs). ATS that do not reveal current client orders are known as dark pools. Page 206 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure Dealers facilitate trading by buying for or selling from their own inventory. Dealers provide liquidity in the market and profit primarily from the spread (difference) between the price at which they will buy (bid price) and the price at which they will sell (ask price) the security or other asset. Some dealers also act as brokers. Broker-dealers have an inherent conflict of interest. As brokers, they should seek the best prices for their clients, but as dealers, their goal is to profit through prices or spreads. As a result, traders typically place limits on how their orders are filled when they transact with broker-dealers. Dealers that trade with central banks when the banks buy or sell government securities in order to affect the money supply are referred to as primary dealers. zyvutsrponlihecaSID Securitizers Securitizers pool large amounts of securities or other assets and then sell interests in the pool to other investors. The returns from the pool, net of the securitizer's fees, are passed through to the investors. By securitizing the assets, the securitizer creates a diversified pool of assets with more predictable cash flows than the individual assets in the pool. This creates liquidity in the assets because the ownership interests are more easily valued and traded. There are also economies of scale in the management costs of large pools of assets and potential benefits from the manager's selection of assets. Assets that are often securitized include mortgages, car loans, credit card receivables, bank loans, and equipment leases. The primary benefit of securitization is to decrease the funding costs for the assets in the pool. A firm may set up a special purpose vehicle (SPV) or special purpose entity (SPE) to buy firm assets, which removes them from the firm's balance sheet and may increase their value by removing the risk that financial trouble at the firm will give other investors a claim to the assets' cash flows. The cash flows from securitized assets can be segregated by risk. The different risk categories are called tranches. The senior tranches provide the most certain cash flows, while the junior tranches have greater risk. Depository Institutions Examples of depository institutions include banks, credit unions, and savings and loans. They pay interest on customer deposits and provide transaction services such as checking accounts. These financial intermediaries then make loans with the funds, which offer diversification benefits. The intermediaries have expertise in evaluating credit quality and managing the risk of a portfolio of loans of various types. Other intermediaries, such as payday lenders and factoring companies, lend money to firms and individuals on the basis of their wages, accounts receivable, and other future cash flows. These intermediaries often finance the loans by issuing commercial paper or other debt securities. ©20 15 Kaplan, Inc. Page 207 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure Securities brokers provide loans to investors who purchase securities on margin. When this margin lending is to hedge funds and other institutions, the brokers are referred to as prime brokers. utsrponmlkigecbaICA The equity owners (stockholders) of banks, brokers, and other intermediaries absorb any loan losses before depositors and other lenders. The more equity capital an intermediary has, the less risk for depositors. Poorly capitalized intermediaries (those with less equity) have less incentive to reduce the risk of their loan portfolios because they have less capital at risk. Insurance Companies Insurance companies are intermediaries, in that they collect insurance premiums in return for providing risk reduction to the insured. The insurance firm can do this efficiently because it provides protection to a diversified pool of policyholders, whose risks of loss are typically uncorrelated. This provides more predictable losses and cash flows compared to a single insurance contract, in the same way that a bank's diversified portfolio of loans diversifies the risk of loan defaults. Insurance firms also provide a benefit to investors by managing the risks inherent in insurance: moral hazard, adverse selection, and fraud. Moral hazard occurs because the insured may take more risks once he is protected against losses. Adverse selection occurs when those most likely to experience losses are the predominant buyers of insurance. In fraud, the insured purposely causes damage or claims fictitious losses so he can collect on his insurance policy. Arbitrageurs In its pure (riskless) form, arbitrage refers to buying an asset in one market and reselling it in another at a higher price. By doing so, arbitrageurs act as intermediaries, providing liquidity to participants in the market where the asset is purchased and transferring the asset to the market where it is sold. In markets with good information, pure arbitrage is rare because traders will favor the markets with the best prices. More commonly, arbitrageurs try to exploit pricing differences for similar instruments. For example, a dealer who sells a call option will often also buy the stock because the call and stock price are highly correlated. Likewise, arbitrageurs will attempt to exploit discrepancies in the pricing of the call and stock. Many (risk) arbitrageurs use complex models for valuation of related securities and for risk control. Creating similar positions using different assets is referred to as replication. This is also a form of intermediation because similar risks are traded in different forms and in different markets. Page 208 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structureywutsrponmlkihgfed Clearinghouses and Custodians Clearinghouses act as intermediaries between buyers and sellers in financial markets and provide: • • • • Escrow services (transferring cash and assets to the respective parties). Guarantees of contract completion. Assurance that margin traders have adequate capital. Limits on the aggregate net order quantity (buy orders minus sell orders) of members. Through these activities, clearinghouses limit counterparty risk, the risk that the other party to a transaction will not fulfill its obligation. In some markets, the clearinghouse ensures only the trades of its member brokers and dealers, who, in turn, ensure the trades of their retail customers. Custodians also improve market integrity by holding client securities and preventing their loss due to fraud or other events that affect the broker or investment manager. LOS 46.e: Compare positions an investor can take in an asset. CFA® Program Curriculum, Volume 5, page 38 An investor who owns an asset, or has the right or obligation under a contract to purchase an asset, is said to have a long position. A short position can result from borrowing an asset and selling it, with the obligation to replace the asset in the future (a short sale). The party to a contract who must sell or deliver an asset in the future is also said to have a short position. In general, investors who are long benefit from an increase in the price of an asset and those who are short benefit when the asset price declines. Hedgers use short positions in one asset to hedge an existing risk from a long position in another asset that has returns that are strongly correlated with the returns of the asset shorted. For example, wheat farmers may take a short position in (i.e., sell) wheat futures contracts. If wheat prices fall, the resulting increase in the value of the short futures position offsets, partially or fully, the loss in the value of the farmer's crop. Professor's Note: As a rule of thumb, hedgers must "do in the futures market what they must do in the future. "Thus, the former who must sell wheat in the future can reduce the risk from wheat price fluctuations by selling wheat futures. The buyer of an option contract is said to be long the option. The seller is short the option and is said to have written the option. Note that an investor who is long (buys) a call option on an asset profits when the value of the underlying asset increases in value, while the party short the option has losses. A long position in a put option on an asset has the right to sell the asset at a specified price and profits when the price of the underlying asset falls, while the party short the option has losses. ©20 15 Kaplan, Inc. Page 209 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure In swaps, each party is long one asset and short the other, so the designation of the long and short side is often arbitrary. Usually, however, the side that benefits from an increase in the quoted price or rate is referred to as the long side. In a currency contract, each party is long one currency and short the other. For example, the buyer of a euro futures contract priced in dollars is long the euro and short the dollar. Short Sales and Positions In a short sale, the short seller (1) simultaneously borrows and sells securities through a broker, (2) must return the securities at the request of the lender or when the short sale is closed out, and (3) must keep a portion of the proceeds of the short sale on deposit with the broker. Short sellers hope to profit from a fall in the price of the security or asset sold short, buying at a lower price in the future in order to repay the loan of the asset originally sold at a higher price. The repayment of the borrowed security or other asset is referred to as "covering the short position." In a short sale, the short seller must pay all dividends or interest that the lender would have received from the security that has been loaned to the short seller. These payments are called payments-in-lieu of dividends or interest. The short seller must also deposit the proceeds of the short sale as collateral to guarantee the eventual repurchase of the security. The broker then earns interest on these funds and may return a portion of this interest to the short seller at a rate referred to as the short rebate rate. The short rebate rate is usually only provided to institutional investors and is typically 0.1 % less than overnight interest rates. If the security is difficult to borrow, the short rebate rate may be lower or negative. The difference between the interest earned on the proceeds from the short sale and the short rebate paid is the return to the lender of the securities. A short sale may also require the short seller to deposit additional margin in the form of cash or short-term riskless securities. Leveraged Positions The use of borrowed funds to purchase an asset results in a leveraged position and the investor is said to be using leverage. Investors who use leverage to buy securities by borrowing from their brokers are said to buy on margin and the borrowed funds are referred to as a margin loan. The interest rate paid on the funds is the call money rate, which is generally higher than the government bill rate. The call money rate is lower for larger investors with better collateral. At the time of a new margin purchase, investors are required to provide a minimum amount of equity, referred to as the initial margin requirement. This requirement may be set by the government, exchange, clearinghouse, or broker. Lower risk in an investor's portfolio will often result in the broker lending more funds. The use of leverage magnifies both the gains and losses from changes in the value of the underlying asset. The additional risk from the use of borrowed funds is referred to as risk from financial leverage. Page 210 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure LOS 46.f: Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 41 The leverage ratio of a margin investment is the value of the asset divided by the value of the equity position. For example, an investor who satisfies an initial margin requirement of 500/0equity has a 2-to-l leverage ratio so that a 100/0increase (decrease) in the price of the asset results in a 200/0increase (decrease) in the investor's equity amount. Example: Margin transaction Given the following information: Shares purchased 1,000 Purchase price per share $100 Annual dividend per share $2.00 Initial margin requirement 400/0 Call money rate 40/0 Commission per share $0.05 Stock price after one year $110 Calculate (1) the leverage ratio and (2) the investor's return on the margin transaction (return on equity) if the stock is sold at the end of one year. Answer: 1. The leverage ratio = 1 / 0.40 = 2.5. 2. The total purchase price is 1,000 x $100 = $100,000. The investor must post initial margin of 400/0 x $100,000 = $40,000. The remaining $60,000 is borrowed. The commission on the purchase is 1,000 x $0.05 = $50. Thus, the total initial equity investment is $40,050. At the end of one year, the stock value is 1,000 x $110 = $110,000, for a gain of $9,950. Dividends received are 1,000 x $2.00 = $2,000. Interest paid is $60,000 x 40/0 = $2,400. The commission on the sale is 1,000 x $0.05 = $50. The gain on the transaction in one year is $9,950 + $2,000 - $2,400 - $50 = $9,500. The return on the equity investment is $9,500 / $40,050 = 23.720/0. The investor's net return is less than the asset total return (100/0price appreciation + 20/0dividend = 120/0)multiplied by the leverage ratio (120/0x 2.5 = 300/0)because of the loan interest and commissions. We can also solve for the return on the margin transaction with the cash flow functions on a financial calculator. The initial cash outflow is the $40,000 initial margin + $50 purchase commission = $40,050. The inflow after one year is the $110,000 stock value + $2,000 dividends - $60,000 margin repayment - $2,400 margin interest - $50 sale commission = $49,550. Using the cash flow functions: CFo = -40,050; CF1 = 49,550; CPT IRR = 23.720/0. ©20 15 Kaplan, Inc. Page 211 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure To ensure that the loan is covered by the value of the asset, an investor must maintain a minimum equity percentage, called the maintenance margin requirement, in the account. This minimum is typically 25% of the current position value, but brokers may require a greater minimum equity percentage for volatile stocks. If the percentage of equity in a margin account falls below the maintenance margin requirement, the investor will receive a margin call, a request to bring the equity percentage in the account back up to the maintenance margin percentage. An investor can satisfy this request by depositing additional funds or depositing other unmargined securities that will bring the equity percentage up to the minimum requirement. If the investor does not meet the margin call, the broker must sell the position. The stock price which results in a margin call can be calculated by using the following formula: margin call price = Po 1-initial margin oP 1- maintenance margin where: Po;;: initial purchase price Example: Margin call price If an investor purchases a stock for $40 per share with an initial margin requirement of 50% and the maintenance margin requirement is 250/0, at what price will the investor get a margin call? Answer: $40(1 - 0.5) = $26.67 1- 0.25 A margin call is triggered at a price below $26.67. In a short sale, the investor must deposit initial margin equal to a percentage of the value of the shares sold short to protect the broker in case the share price increases. An increase in the share price can decrease the margin percentage below the maintenance margin percentage and generate a margin call. LOS 46.g: Compare execution, validity, and clearing instructions. LOS 46.h: Compare market orders with limit orders. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 44 Securities dealers provide prices at which they will buy and sell shares. The bid price is the price at which a dealer will buy a security. The ask or offer price is the price at which a dealer will sell a security. The difference between the bid and ask prices is referred to Page 212 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure as the bid-ask spread and is the source of a dealer's compensation. The bid and ask are quoted for specific trade sizes (bid size and ask size). yxwvutsrqponmlkjihgfedcbaTSPNLIC Professor's Note: Calculations with bid and ask prices are unlikely to appear on the Level I exam but they do appear at Level II. If you need to work with bid and ask prices, just remember that the price you get will be the one that is worse for you. fI • • Securities: If you are buying, you must pay the higher price. If you are selling, you only receive the lower price. Currencies: The bid or ask price you get is the one that givesyou less of the currency you are acquiring. This works regardless of which way the exchange rate is quoted. The quotation in the market is the highest dealer bid and lowest dealer ask from among all dealers in a particular security. More liquid securities have market quotations with bid-ask spreads that are lower (as a percentage of share price) and therefore have lower transactions costs for investors. Traders who post bids and offers are said to make a market, while those who trade with them at posted prices are said to take the market. When investors want to buy or sell, they must enter orders that specify the size of the trade and whether to buy or sell. The order can also include execution instructions that specify how to trade, validity instructions that specify when the order can be filled, and clearing instructions that specify how to settle the trade. Execution Instructions The most common orders, in terms of execution instructions, are market or limit orders. A market order instructs the broker to execute the trade immediately at the best possible price. A limit order places a minimum execution price on sell orders and a maximum execution price on buy orders. For example, a buy order with a limit of $6 will be executed immediately as long as the shares can be purchased for $6 or less. A market order is often appropriate when the trader wants to execute quickly, as when the trader has information she believes is not yet reflected in market prices. The disadvantage of market orders is that they may execute at unfavorable prices, especially if the security has low trading volume relative to the order size. A market buy order may execute at a high price or a market sell order may execute at a low price. Executing at an unfavorable price represents a concession by the trader for immediate liquidity. Unfortunately, these price concessions are unpredictable. To avoid price execution uncertainty, a trader can place a limit order instead of the market order. The disadvantage of the limit order is that it might not be filled. For example, if a trader places a limit buy order of $50 and no one is willing to sell at $50, the order will not be filled. Furthermore, if the stock price rises over time, the trader misses out on the gains. A limit buy order above the best ask or a limit sell order below the best bid are said to be marketable or aggressivelypriced because at least part of the order is likely to execute ©20 15 Kaplan, Inc. Page 213 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure immediately. If the limit price is between the best bid and the best ask, a limit order is said to be making a new market or inside the market. Limit orders waiting to execute are called standing limit orders. wtsrponmkihgfedbaSO A limit buy order at the best bid or a limit sell order at the best ask are said to make the market. Again, the order might not be filled. A buy order with a limit price below the best bid, or a sell order with a limit price above the best ask, is said to be behind the market. It will likely not execute until security prices move toward the limit price. A limit buy order with a price considerably lower than the best bid, or a limit sell order with a price significantly higher than the best ask, is said to be for from the market. Other execution instructions concern the volume of the trade. All-or-nothing orders execute only if the whole order can be filled. Orders can specify the minimum size of a trade, which is beneficial when trading costs depend on the number of executed trades rather than the size of the order. Trade visibility can also be specified. Hidden orders are those for which only the broker or exchange knows the trade size. These are useful for investors that have a large amount to trade and do not want to reveal their intentions. Traders can also specify display size, where some of the trade is visible to the market, but the rest is not. These are also referred to as iceberg orders because part of most of the order is hidden from view. They allow the investor to advertise some of the trade, with the rest of the trade potentially executed once the visible part has executed. Sometimes entering trades for part of the position the trader wishes to establish is a way to estimate the liquidity of, or the buying interest in, the security in question. Validity Instructions Validity instructions specify when an order should be executed. Most orders are day orders, meaning they expire if unfilled by the end of the trading day. Good-till-cancelled orders last until they are filled. Immediate-or-cancel orders are cancelled unless they can be filled immediately. They are also known as fill-or-kill orders. Good-on-close orders are only filled at the end of the trading day. If they are market orders, they are referred to as market-on-close orders. These are often used by mutual funds because their portfolios are valued using closing prices. There are also good-on-open orders. Stop Orders Stop orders are those that are not executed unless the stop price has been met. They are often referred to as stop loss orders because they can be used to prevent losses or to protect profits. Suppose an investor purchases a stock for $50. If the investor wants to sellout of the position if the price falls 100/0 to $45, he can enter a stop-sell order at $45. If the stock trades down to $45 or lower, this triggers a market order to sell. There is no guarantee that the order will execute at $45, and a rapidly falling stock could be sold at a price significantly lower than $45. A stop-buy is entered with at stop (trigger) above the current market price. There are two primary reasons a trader would enter a stop-buy order. (1) A trader with a short Page 214 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure position could attempt to limit losses from an increasing stock price with a stop-buy order. (2) It is often said, "You don't get paid for being right until the market agrees with you." With this in mind, an investor who believes a stock is undervalued, but does not wish to own it until there are signs that market participants are being convinced of this undervaluation, may place a stop-buy order at a price some specific percentage above the • current prIce. Note that stop orders reinforce market momentum. Stop-sell orders execute when market prices are falling, and stop-buy orders execute when the market is rising. Execution prices for stop orders are therefore often unfavorable. Example: Using stop orders Raymond Flowers believes that the shares of Acme Corp. that he owns are overvalued currently but knows that stocks often continue to increase above their intrinsic values for some time before correcting. What type of order should Flowers place if he wants to sell his shares when the price begins to fall a significant amount? Answer: Flowers should enter a good-till-cancelled stop-sell order at a price some percentage below the current level. If, for example, the shares are trading at 40, he could enter a stop-sell order at 36, 100/0 below the current level. Investors sometimes move these stops up as a stock continues to increase in price. In response to a price increase to 42, Flowers might move his stop-sell order up to 37.80, 100/0 below the new price. Note that a limit order to sell with a limit price below the current market price would likely execute immediately. Clearing Instructions Clearing instructions tell the trader how to clear and settle a trade. They are usually standing instructions and not attached to an order. Retail trades are typically cleared and settled by the broker, whereas institutional trades may be settled by a custodian or another broker, which might be the trader's prime broker. Using two brokers allows the investor to keep one broker as her prime broker for margin and custodial services while using a variety of other brokers for specialized execution. One important clearing instruction is whether a sell order is a short sale or long sale. In the former, the broker must confirm that the security can be borrowed and in the latter, that the security can be delivered. ©20 15 Kaplan, Inc. Page 215 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure LOS 46.i: Define primary and secondary markets and explain how secondary markets support primary markets. urpomligecaVPFCA CFA® Program Curriculum, Volume 5, page 50 Primary capital markets refer to the sale of newly issued securities. New equity issues involve either: • • New shares issued by firms whose shares are already trading in the marketplace. These issues are called seasoned offerings or secondary issues. First-time issues by firms whose shares are not currently publicly traded. These are called initial public offerings (IPOs). Secondary financial markets are where securities trade after their initial issuance. Placing a buy order on the London Stock Exchange is an order in the secondary market and will result in purchase of existing shares from their current owner. Primary Market: Public Offerings Corporate stock or bond issues are almost always sold with the assistance of an investment banking firm. The investment bank finds investors who agree to buy part of the issue. These are not actual orders but are referred to as indications of interest. When the number of shares covered by indications of interest are greater (less) than the number of shares to be offered, the offering price may be adjusted upward (downward). This process of gathering indications of interest is referred to as book building. In London, the book builder is referred to as the book runner. In Europe, an accelerated book build occurs when securities must be issued quickly. To build a book, the investment bank disseminates information about the firm's financials and prospects. The issuer must also make disclosures including how the funds will be used. The most common wayan investment bank assists with a security issuance is through an underwritten offering. Here, the investment bank agrees to purchase the entire issue at a price that is negotiated between the issuer and bank. If the issue is undersubscribed, the investment bank must buy the unsold portion. In the case of an IPO, the investment bank also agrees to make a market in the stock for a period after the issuance to provide price support for the issue. An investment bank can also agree to distribute shares of an IPO on a best efforts basis, rather than agreeing to purchase the whole issue. If the issue is undersubscribed, the bank is not obligated to buy the unsold portion. Note that investment banks have a conflict of interest in an underwritten offer. As the issuer's agents, they should set the price high to raise the most funds for the issuer. But, as underwriters, they would prefer that the price be set low enough that the whole issue sells. This also allows them to allocate portions of an undervalued IPO to their clients. This results in IPOs typically being underpriced. Issuers also could have an interest in underpricing the IPO because of the negative publicity when an undersubscribed IPO initially trades at a price below the IPO price investors pay. An IPO that is oversubscribed and has the expectation of trading significantly above its IPO price is referred to as a hot issue. Page 216 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure Primary Market: Private Placements and Other Transactions In a private placement, securities are sold directly to qualified investors, typically with the assistance of an investment bank. Qualified investors are those with substantial wealth and investment knowledge. Private placements do not require the issuer to disclose as much information as they must when the securities are being sold to the public. The issuance costs are less with a private placement and the offer price is also lower because the securities cannot be resold in public markets, making them less valuable than shares registered for public trading. In a shelf registration, a firm makes its public disclosures as in a regular offering but then issues the registered securities over time when it needs capital and when the markets are favorable. A dividend reinvestment plan CORP or DRIP) allows existing shareholders to use their dividends to buy new shares from the firm at a slight discount. In a rights offering, existing shareholders are given the right to buy new shares at a discount to the current market price. Shareholders tend to dislike rights offerings because their ownership is diluted unless they exercise their rights and buy the additional shares. However, rights can be traded separately from the shares themselves in some • circumstances. In addition to firms issuing securities, governments issue short-term and long-term debt, either by auction or through investment banks. Importance of the Secondary Market Secondary markets are important because they provide liquidity and price/value information. Liquid markets are those in which a security can be sold quickly without incurring a discount from the current price. The better the secondary market, the easier it is for firms to raise external capital in the primary market, which results in a lower cost of capital for firms with shares that have adequate liquidity. LOS 46.j: Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 54 The trading of securities in the secondary market has encouraged the development of market structures to facilitate trading. Trading can be examined according to when securities are traded and how they are traded. Securities markets may be structured as call markets or continuous markets. In call markets, the stock is only traded at specific times. Call markets are potentially very liquid when in session because all traders are present, but they are obviously illiquid between sessions. In a call market, all trades, bids, and asks are declared, and then one negotiated price is set that clears the market for the stock. This method is used in ©20 15 Kaplan, Inc. Page 217 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure smaller markets but is also used to set opening prices and prices after trading halts on major exchanges. In continuous markets, trades occur at any time the market is open. The price is set by either the auction process or by dealer bid-ask quotes. Market Structures There are three main categories of securities markets: quote-driven markets where investors trade with dealers, order-driven markets where rules are used to match buyers and sellers, and brokered markets where investors use brokers to locate a counterparty to a trade. yvutsrqponmlkihgfedcbaQOMD Quote-Driven Markets In quote-driven markets, traders transact with dealers (market makers) who post bid and ask prices. Dealers maintain an inventory of securities. Quote-driven markets are thus sometimes called dealer markets, price-driven markets, or over-the-counter markets. Most securities other than stocks trade in quote-driven markets. Trading often takes place electronically. Order-Driven Markets In order-driven markets, orders are executed using trading rules, which are necessary because traders are usually anonymous. Exchanges and automated trading systems are examples of order-driven markets. Two sets of rules are used in these markets: order matching rules and trade pricing rules. Order matching rules establish an order precedence hierarchy. Price priority is one criteria, where the trades given highest priority are those at the highest bid (buy) and lowest ask (sell). If orders are at the same prices, a secondary precedence rule gives priority to non-hidden orders and earliest arriving orders. These rules encourage traders to price their trades aggressively, display their entire orders, and trade earlier, thereby improving liquidity. After orders are created using order matching rules, trade pricing rules are used to determine the price. Under the uniform pricing rule, all orders trade at the same price, which is the price that results in the highest volume of trading. The discriminatory pricing rule uses the limit price of the order that arrived first as the trade price. In an electronic crossing network, the typical trader is an institution. Orders are batched together and crossed (matched) at fixed points in time during the day at the average of the bid and ask quotes from the exchange where the stock primarily trades. This pricing rule is referred to as the derivative pricing rule because it is derived from the security's main market. The price is not determined by orders in the crossing network. Page 218 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and StructureutsrpomlkigedcaVPM Brokered Markets In brokered markets, brokers find the counterparty in order to execute a trade. This service is especially valuable when the trader has a security that is unique or illiquid. Examples are large blocks of stock, real estate, and artwork. Dealers typically do not carry an inventory of these assets and there are too few trades for these assets to trade in order-driven markets. Market Information A market is said to be pre-trade transparent if investors can obtain pre-trade information regarding quotes and orders. A market is post-trade transparent if investors can obtain post-trade information regarding completed trade prices and sizes. Buy-side traders value transparency because it allows them to better understand security values and trading costs. Dealers, on the other hand, prefer opaque markets because this provides them with an informational advantage over traders who trade less frequently in the security. Transactions costs and bid-ask spreads are larger in opaque markets. LOS 46.k: Describe characteristics of a well-functioning financial system. CFA® Program Curriculum, Volume 5, page 58 A well-functioning financial system allows entities to achieve their purposes. More specifically, complete markets fulfill the following: • • • • Investors can save for the future at fair rates of return. Creditworthy borrowers can obtain funds. Hedgers can manage their risks. Traders can obtain the currencies, commodities, and other assets they need. If a market can perform these functions at low trading costs (including commissions, bid-ask spreads, and price impacts), it is said to be operationally efficient. If security prices reflect all the information associated with fundamental value in a timely fashion, then the financial system is informationally efficient. A well-functioning financial system has complete markets that are operationally and informationally efficient, with prices that reflect fundamental values. A well-functioning financial system has financial intermediaries that: • • • • • • • • Organize trading venues, including exchanges, brokerages, and alternative trading systems. Supply liquidity. Securitize assets so that borrowers can obtain funds inexpensively. Manage banks that use depositor capital to fund borrowers. Manage insurance firms that pool unrelated risks. Manage investment advisory services that assist investors with asset management inexpensively. Provide clearinghouses that settle trades. Manage depositories that provide for asset safety. ©20 15 Kaplan, Inc. Page 219 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure The benefits of a well-functioning financial system are tremendous. Savers can fund entrepreneurs who need capital to fund new companies. Company risks can be shared so that risky companies can be funded. These benefits are enhanced because the transactions can occur among strangers, widening the opportunities for capital formation and risk sharing in the economy. Furthermore, in informationally efficiently markets, capital is allocated to its most productive use. That is, they are allocationally efficient. Informational efficiency is brought about by traders who bid prices up and down in response to new information that changes estimates of securities' fundamental values. If markets are operationally efficient, security prices will be more informationally efficient because low trading costs encourage trading based on new information. The existence of accounting standards and financial reporting requirements also reduces the costs of obtaining information and increases security values. LOS 46.1: Describe objectives of market regulation. yutsrponmlihgfedcaVPIFDCA CFA ® Program Curriculum, Volume 5, page 60 Without market regulation, many problems could persist in financial markets: • • • • Fraud and theft: In complex financial markets, the potential for theft and fraud increases because investment managers and others can take advantage of unsophisticated investors. Furthermore, if returns are often random, it is difficult for investors to determine if their agents (e.g., investment managers and brokers) are performing well. Insider trading: If investors believe traders with inside information will exploit them, they will exit the market and liquidity will be reduced. Costly information: If obtaining information is relatively expensive, markets will not be as informationally efficient and investors will not invest as much. Defaults: Parties might not honor their obligations in markets. To solve these problems, market regulation should: • • • • • Protect unsophisticated investors so that trust in the markets is preserved. Require minimum standards of competency and make it easierfor investors to evaluate performance. The CFA Program and the Global Investment Performance Standards are part of this effort. Prevent insiders from exploiting other investors. Require common financial reporting requirements (e.g., ht ose of the International Accounting Standards Board) so that information gathering is less expensive. Require minimum levels of capital so that market participants will be able to honor their long-term commitments. This is especially important for insurance companies and pension funds that individuals depend on for their financial future. With capital at stake, market participants have more incentive to be careful about the risks they take. Regulation can be provided by governments as well as industry groups. For example, most exchanges, clearinghouses, and dealer trade organizations are self-regulating organizations (SROs), meaning that they regulate their members. Governments sometimes delegate regulatory authority to SROs. Page 220 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure When they fail to address the problems mentioned above, financial markets do not function well. Liquidity declines, firms shun risky projects, new ideas go unfunded, and economic growth slows. ©20 15 Kaplan, Inc. Page 221 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure LOS 46.a The three main functions of the financial system are to: 1. Allow entities to save, borrow, issue equity capital, manage risks, exchange assets, and utilize information. 2. Determine the return that equates aggregate savings and borrowing. 3. Allocate capital efficiently. LOS 46.b Assets and markets can be classified as: • Financial assets (e.g., securities, currencies, derivatives) versus real assets (e.g., real estate, equipment). • Debt securities versus equity securities. • Public securities that trade on exchanges or through dealers versus private securities. • Physical derivative contracts (e.g., on grains or metals) versus financial derivative contracts (e.g., on bonds or equity indexes). • Spot versus future delivery markets. • Primary markets (issuance of new securities) versus secondary markets (trading of previously issued securities). • Money markets (short-term debt instruments) versus capital markets (longer-term debt instruments and equities). • Traditional investment markets (bonds, stocks) versus alternative investment markets (e.g., real estate, hedge funds, fine art). LOS 46.c The major types of assets are securities, currencies, contracts, commodities, assets. and real Securities include fixed income (e.g., bonds, notes, commercial paper), equity (common stock, preferred stock, warrants), and pooled investment vehicles (mutual funds, exchange-traded funds, hedge funds, asset-backed securities). Contracts include futures, forwards, options, swaps, and insurance contracts. Commodities include agricultural products, industrial and precious metals, and energy products and are traded in spot, forward, and futures markets. Most national currencies are traded in spot markets and some are also traded in forward and futures markets. Page 222 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure LOS 46.d Financial intermediaries perform the following roles: • Brokers, exchanges, and alternative trading systems connect buyers and sellers of the same security at the same location and time. They provide a centralized location for trading. • Dealers match buyers and sellers of the same security at different points in time. • Arbitrageurs connect buyers and sellers of the same security at the same time but in different venues. They also connect buyers and sellers of non-identical securities of similar risk. • Securitizers and depository institutions package assetsinto a diversified pool and sell interests in it. Investors obtain greater liquidity and choose their desired risk level. • Insurance companies create a diversified pool of risks and manage the risk inherent in providing insurance. • Clearinghouses reduce counterparty risk and promote market integrity. LOS 46.e A long position in an asset represents current or future ownership. A long position benefits when the asset increases in value. A short position represents an agreement to sell or deliver an asset or results from borrowing an asset and selling it (i.e., a short sale). A short position benefits when the asset decreases in value. When an investor buys a security by borrowing from a broker, the investor is said to buy on margin and has a leveraged position. The risk of investing borrowed funds is referred to as financial leverage. More leverage results in greater risk. LOS 46.£ The leverage ratio is the value of the asset divided by the value of the equity position. Higher leverage ratios indicate greater risk. The return on a margin transaction is the increase in the value of the position after deducting selling commissions and interest charges, divided by the amount of funds initially invested, including purchase commissions. The maintenance margin is the minimum percentage of equity that a margin investor is required to maintain in his account. If the investor's equity falls below the maintenance margin, the investor will receive a margin call. The stock price that will result in a margin call is: margin call price = Po 1- initial margin 1- maintenance margin where: Po = initial purchase price ©20 15 Kaplan, Inc. Page 223 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure LOS 46.g Execution instructions specify how to trade. Market orders and limit orders are examples of execution instructions. Validity instructions specify when an order can be filled. Day orders, good-til-cancelled orders, and stop orders are examples of validity instructions. Clearing instructions specify how to settle a trade. LOS 46.h A market order is an order to execute the trade immediately at the best possible price. A market order is appropriate when the trader wants to execute a transaction quickly. The disadvantage of a market order is that it may execute at an unfavorable price. A limit order is an order to trade at the best possible price, subject to the price satisfying the limit condition. A limit order avoids price execution uncertainty. The disadvantage of a limit order is that it may not be filled. A buy (sell) order with a limit of $18 will only be executed if the security can be bought (sold) at a price of $18 or less (more). LOS 46.i New issues of securities are sold in primary capital markets. Secondary financial markets are where securities trade after their initial issuance. In an underwritten offering, the investment bank guarantees that the issue will be sold at a price that is negotiated between the issuer and bank. In a best efforts offering, the bank acts only as a broker. In a private placement, a firm sells securities directly to qualified investors, without the disclosures of a public offering. A liquid secondary market makes it easier for firms to raise external capital in the primary market, which results in a lower cost of capital for firms. LOS 46.j There are three main categories of securities markets: 1. Quote-driven markets: Investors trade with dealers that maintain inventories of • • • secunnes, currencies, or contracts. 2. Order-driven markets: Order-matching and trade-pricing rules are used to match the orders of buyers and sellers. 3. Brokered markets: Brokers locate a counterparty to take the other side of a buy or sell order. In call markets, securities are only traded at specific times. In continuous markets, trades occur at any time the market is open. Page 224 ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure LOS 46.k A well-functioning financial system has the following characteristics: • Complete markets: Savers receive a return, borrowers can obtain capital, hedgers can manage risks, and traders can acquire needed assets. • Operational efficiency: Trading costs are low. • Informational efficiency: Prices reflect fundamental information quickly. • Allocational efficiency: Capital is directed to its highest valued use. LOS 46.1 The objectives of market regulation are to: • Protect unsophisticated investors. • Establish minimum standards of competency. • Help investors to evaluate performance. • Prevent insiders from exploiting other investors. • Promote common financial reporting requirements so that ni formation gathering is less expensive. • Require minimum levels of capital so that market participants will be able to honor their commitments and be more careful about their risks. ©20 15 Kaplan, Inc. Page 225 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure 1. Daniel Ferramosco is concerned that a long-term bond he holds might default. He therefore buys a contract that will compensate him in the case of default. What type of contract does he hold? A. Physical derivative contract. B. Primary derivative contract. C. Financial derivative contract. 2. A financial intermediary buys a stock and then resells it a few days later at a higher price. Which intermediary would this most likely describe? A. Broker. B. Dealer. C. Arbitrageur. ytsomlkiec Page 226 3. Which of the following is most similar to a short position in the underlying asset? A. Buying a put. B. Writing a put. C. Buying a call. 4. An investor buys 1,000 shares of a stock on margin at a price of $50 per share. The initial margin requirement is 400/0 and the margin lending rate is 30/0. The investor's broker charges a commission of $0.01 per share on purchases and sales. The stock pays an annual dividend of $0.30 per share. One year later, the investor sells the 1,000 shares at a price of $56 per share. The investor's rate of return is closest to: A. 120/0. B. 270/0. C. 360/0. nA 5. A stock is selling at $50. An investor's valuation model estimates its intrinsic value to be $40. Based on her estimate, she would most likely place a: A. short-sale order. B. stop order to buy. C. market order to buy. 6. Which of the following limit buy orders would be the most likely to go unexecuted? A. A marketable order. B. An order behind the market. C. An order making a new market. 7. New issues of securities are transactions in the: A. primary market. B. secondary market. C. seasoned market. ©2015 Kaplan, Inc. Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure 8. In which of the following types of markets do stocks trade any time the market is open? A. Exchange markets. B. Call markets. C. Continuous markets. 9. A market is said to be informationally efficient if it features: A. market prices that reflect all available information about the value of the securities traded. B. timely and accurate information about current supply and demand conditions. C. many buyers and sellers that are willing to trade at prices above and below the prevailing market price. 10. Which of the following would least likely be an objective of market regulation? A. Reduce burdensome accounting standards. B. Make it easier for investors to evaluate performance. C. Prevent investors from using inside information in securities trading. ytslkiea ©20 15 Kaplan, Inc. Page 227 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #46 - Market Organization and Structure 1. C Daniel holds a derivative contract that has a value determined by another financial contract; in this case, the long-term bond. 2. B This situation best describes a dealer. A dealer buys an asset for its inventory in the hopes of reselling it later at a higher price. Brokers stand between buyers and sellers of the same security at the same location and time. Arbitrageurs trade in the same security simultaneously in different markets. 3. A Buying a put is most similar to a short position in the underlying asset because the put increases in value if the underlying asset value decreases. The writer of a put and the holder of a call have a long exposure to the underlying asset because their positions increase in value if the underlying asset value increases. 4.B B The total purchase price is 1,000 x $50 = $50,000. The investor must post initial margin of 400/0 x $50,000 = $20,000. The remaining $30,000 is borrowed. The commission on the purchase is 1,000 x $0.01 = $10. Thus, the initial equity investment is $20,010. In one year, the sales price is 1,000 x $56 = $56,000. Dividends received are 1,000 x $0.30 = $300. Interest paid is $30,000 x 3% = $900. The commission on the sale is 1,000 x $0.01 = $10. Thus the ending value is $56,000 - $30,000 + $300 - $900 - $10 = $25,390. The return on the equity investment is $25,390 / $20,010 - 1 = 26.890/0. 5. A If the investor believes the stock is overvalued in the market, the investor should place a short-sale order, which would be profitable if the stock moves toward her value estimate. 6. B A behind-the-market limit order would be least likely executed. In the case of a buy, the limit buy order price is below the best bid. It will likely not execute until security prices decline. A marketable buy order is the most likely to trade because it is close to the best ask price. In an order that is making a new market or inside the market, the limit buy order price is between the best bid and ask. 7. A The primary market refers to the market for newly issued securities. 8. C Continuous markets are defined as markets where stocks can trade any time the market is open. Some exchange markets are call markets where orders are accumulated and executed at specific times. 9. A Informational efficiency means the prevailing price reflects all available information about the value of the asset, and the price reacts quickly to new information. 10. A Page 228 Market regulation should require financial reporting standards so that information gathering is less expensive and the informational efficiency of the markets is enhanced. ©20 15 Kaplan, Inc. The following is a review of the Equity: Market Organization, Market Indices, and Market Efficiency principles designed to address the learning outcome statements set forth by CFA Institute. CrossReference to CFA Institute Assigned Reading #47.YUTSRNMKIEDCA SECURITY MARKET INDICES Study Session 13XMEA EXAM Focus Security market indexes are used to measure the performance of markets and investment managers. Understand the construction, calculation, and weaknesses of price-weighted, market capitalization-weighted, and equal-weighted indexes. Be familiar with the various security indexes and their potential weaknesses. LOS 47.a: Describe a security market index. urpomligecaVPFCA CFA® Program Curriculum, Volume 5, page 78 A security market index is used to represent the performance of an asset class, security market, or segment of a market. They are usually created as portfolios of individual securities, which are referred to as the constituent securities of the index. An index has a numerical value that is calculated from the market prices (actual when available, or estimated) of its constituent securities at a point in time. An index return is the percentage change in the index's value over a period of time. LOS 47.b: Calculate and interpret the value, price return, and total return of an index. CFA® Program Curriculum, Volume 5, page 79 An index return may be calculated using a price index or a return index. A price index uses only the prices of the constituent securities in the return calculation. A rate of return that is calculated based on a price index is referred to as a price return. A return index includes both prices and income from the constituent securities. A rate of return that is calculated based on a return index is called a total return. If the assets in an index produce interim cash flows such as dividends or interest payments, the total return will be greater than the price return. Once returns are calculated for each period, they then can be compounded together to arrive at the return for the measurement period: where: Rp = portfolio return during the measurement period k = total number of subperiods RSk = portfolio return during the subperiod k k ©20 15 Kaplan, Inc. Page 229 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #47 - Security Market Indices For example, if the returns for the first two periods were 0.500/0 and 1.040/0, they would be geometrically linked to produce 1.550/0: Rp = (1 + RS1)(1 + RS2) -1 = (1.005)(1.0104) -1 = 0.0155 or 1.550/0 If the starting index value is 100, its value after two periods would be 100 x 1.0155 ;:; 101.55. LOS 47.c: Describe the choices and issues in index construction and management. utrpomlkigecaVPFCA CFA ® Program Curriculum, Volume 5, page 82 Index providers must make several decisions: • • • • • What is the target market the index is intended to measure? Which securities from the target market should be included? How should the securities be weighted in the index? How often should the index be rebalanced? When should the selection and weighting of securities be re-examined? The target market may be defined very broadly (e.g., stocks in the United States) or narrowly (e.g., small-cap value stocks in the United States). It may also be defined by geographic region or by economic sector (e.g., cyclical stocks). The constituent stocks in the index could be all the stocks in that market or just a representative sample. The selection process may be determined by an objective rule or subjectively by a committee. LOS 47.d: Compare the different weighting methods used in index • constructron. CFA ® Program Curriculum, Volume 5, page 83 Weighting schemes for stock indexes include price weighting, equal weighting, market capitalization weighting, float-adjusted market capitalization weighting, and fundamental weighting. A price-weighted index is simply an arithmetic average of the prices of the securities included in the index. The divisor of a price-weighted index is adjusted for stock splits and changes in the composition of the index when securities are added or deleted, such that the index value is unaffected by such changes. The advantage of a price-weighted index is that its computation is simple. One disadvantage is that a given percentage change in the price of a higher priced stock has a greater impact on the index's value than does an equal percentage change in the price of a lower priced stock. Put another way, higher priced stocks have more weight in the calculation of a price-weighted index. Additionally, a stock's weight in the index going forward changes if the firm splits its stock, repurchases stock, or issues stock dividends, as all of these actions will affect the price of the stock and therefore its weight in the index. A portfolio that has an equal number of shares in each of the constituent stocks Page 230 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #47 - Security Market Indices will have price returns (ignoring dividends) that will match the returns of a priceweighted index. Two major price-weighted indexes are the Dow Jones Industrial Average (DJIA) and the Nikkei Dow Jones Stock Average. The DJIA is a price-weighted index based on 30 U.S. stocks. The Nikkei Dow is constructed from the prices of 225 stocks that trade in the first section of the Tokyo Stock Exchange. An equal-weighted index is calculated as the arithmetic average return of the index stocks and, for a given time period, would be matched by the returns on a portfolio that had equal dollar amounts invested in each index stock. As with a price-weighted index, an advantage of an equal-weighted index is its simplicity. sA One complication with an equal-weighted index return is that a matching portfolio would have to be adjusted periodically (rebalanced) as prices change so that the values of all security positions are made equal each period. The portfolio rebalancing required to match the performance of an equal-weighted index creates high transactions costs that would decrease portfolio returns. Another concern with an equal-weighted index is that the weights placed on the returns of the securities of smaller capitalization firms are greater than their proportions of the overall market value of the index stocks. Conversely, the weights on the returns of large capitalization firms in the index are smaller than their proportions of the overall market value of the index stocks. The Value Line Composite Average and the Financial Times Ordinary Share Index are well-known examples of equal-weighted indexes. A market capitalization-weighted index (or value-weighted index) has weights based on the market capitalization of each index stock (current stock price multiplied by the number of shares outstanding) as a proportion of the total market capitalization of all the stocks in the index. A market capitalization-weighted index return can be matched with a portfolio in which the value of each security position in the portfolio is the same proportion of the total portfolio value as the proportion of that security's market capitalization to the total market capitalization of all of the securities included in the index. This weighting method more closely represents changes in aggregate investor wealth than price weighting. Because the weight of an index stock is based on its market capitalization, a market capitalization-weighted index does not need to be adjusted when a stock splits or pays a stock dividend. An alternative to using a firm's market capitalization to calculate its weight in an index is to use its market float. A firm's market float is the total value of the shares that are actually available to the investing public and excludes the value of shares held by controlling stockholders because they are unlikely to sell their shares. For example, the float for Microsoft would exclude shares owned by Bill Gates and Paul Allen (the founders) and those of certain other large shareholders as well. The market float is often calculated excluding those shares held by corporations or governments as well. Sometimes the market float calculation excludes shares that are not available to foreign buyers and is then referred to as the free float. The reason for this is to better match the ©20 15 Kaplan, Inc. Page 231 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #47 - Security Market Indices index weights of stocks to their proportions of the total value of all the shares of index stocks that are actually available to investors. A float-adjusted market capitalization-weighted index is constructed like a market capitalization-weighted index. The weights, however, are based on the proportionate value of each firm's shares that are available to investors to the total market value of the shares of index stocks that are available to investors. Firms with relatively large percentages of their shares held by controlling stockholders will have less weight than they have in an unadjusted market-capitalization index. The advantage of market capitalization-weighted indexes of either type is that index security weights represent proportions of total market value. The primary disadvantage of value-weighted indexes is that the relative impact of a stock's return on the index increases as its price rises and decreases as its price falls. This means that stocks that are possibly overvalued are given disproportionately high weights in the index and stocks that are possibly undervalued are given disproportionately low weights. Holding a portfolio that tracks a value-weighted index is, therefore, similar to following a momentum strategy, under which the most successful stocks are given the greatest weights and poor performing stocks are underweighted. The Standard and Poor's 500 (S&P 500) Index Composite is an example of a market capitalization-weighted index. An index that uses fundamental weighting uses weights based on firm fundamentals, such as earnings, dividends, or cash flow. In contrast to market capitalization index weights, these weights are unaffected by the share prices of the index stocks (although related to them over the long term). Fundamental weights can be based on a single measure or some combination of fundamental measures. An advantage of a fundamental-weighted index is that it avoids the bias of market capitalization-weighted indexes toward the performance of the shares of overvalued firms and away from the performance of the shares of undervalued firms. A fundamentalweighted index will actually have a value tilt, overweighting firms with high value-based metrics such as book-to-market ratios or earnings yields. Note that a firm with a high earnings yield (total earnings to total market value) relative to other index firms will by construction have a higher weight in an earnings-weighted index because, among index stocks, its earnings are high relative to its market value. LOS 47 .e: Calculate and analyze the value and return of an index given its weighting method. utrponmlihgecaWVPFCA CFA ® Program Curriculum, Volume 5, page 83 Price Weighting A price-weighted index adds the market prices of each stock in the index and divides this total by the number of stocks in the index. The divisor, however, must be adjusted for Page 232 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #47 - Security Market Indices stock splits and other changes in the index portfolio to maintain the continuity of the • • serres over tirne. pnlcaSKI . . h d i d sum of stock prices price-weig te in ex = -------------'''----------number of stocks in index adjusted for splits niYX Example: Price-weighted index Given the information for the three stocks presented in the following figure, calculate a price-weighted index return over a Ivmonth period. Index Firm Data yurnmihecbaXSPJD Share Price December 31, 20X6 Share Price January 31, 20X7 $20 Stock Y $10 $20 Stock Z $60 $40 Stock X $15 Answer: The price-weighted index is (10 + 20 + 60) / 3 = 30 as of December 31 and (20 + 15 + 40) / 3 = 25 as of January 31. Hence, the price-weighted I-month percentage return • IS: 25 --1 30 = -16.70/0 Example: Adjusting a price-weighted index for stock splits At the market close on day 1, Stock A has a price of $10, Stock B has a price of $20, and Stock C has a price of $90. The value of a price-weighted index of these three stocks is (10 + 20 + 90) / 3 = 40 at the close of trading. If Stock C splits 2-for-I, effective on day 2, what is the new denominator for the index? Answer: The effect of the split on the price of Stock C, in the absence of any change from the price at the end of day 1, would be to reduce it to $90 / 2 = $45. The index denominator will be adjusted so that the index value would remain at 40 if there were no changes in the stock prices other than to adjust for the split. The new denominator, d, must satisfy (10 + 20 + 45) / d = 40 and equals 1.875. d The returns on a price-weighted index could be matched by purchasing an equal number of shares of each stock represented in the index. Because the index is price weighted, a percentage change in a high-priced stock will have a relatively greater effect on the index than the same percentage change in a low-priced stock. ©20 15 Kaplan, Inc. Page 233 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #47 - Security Market IndiceszyutsrponmlkihgfedcbaWSPONMDC Market Capitalization Weighting A market capitalization-weighted index is calculated by summing the total value (current stock price multiplied by the number of shares outstanding) of all the stocks in the index. This sum is then divided by a similar sum calculated during the selected base period. The ratio is then multiplied by the index's base value (typically 100). For example, if the total market values of the index portfolio on December 31 and January 31 are $80 million and $95 million, respectively, the index value at the end of January is: . d al current total market value of index stocks current In ex v ue = base year total market value of index stocks liXB X b ase year . d ill al ex v ue . $95 million current Index value = xl 00 = 118.75 $80 million Thus, the market capitalization-weighted (118.75/100) -1 = index percentage return is: 18.750/0 The following example of price-weighting versus market value-weighting shows how these two indexes are calculated and how they differ. Example: Price-weighted vs. market capitalization-weighted indexes Consider the three firms described below. Compare the effects on a price-weighted index and a market capitalization-weighted index if Stock A doubles in price or if Stock C doubles in price. Assume the period shown in the table is the base period for the market capitalization-weighted index and that its base value is 100. Index Firm Data Page 234 Company Number of Shares Outstanding (ODDs) Stock Price A 100 $100 $10,000 B 1,000 $10 $10,000 C 20,000 $1 $20,000 ©2015 Kaplan, Inc. Capitalization (ODDs) Study Session 13 Cross- Reference to CFA Institute Assigned Reading #47 - Security Market Indices Answer: The price-weighted index equals: 100 + 10 + 1 = 37 3 If Stock A doubles in price to $200, the price-weighted index value is: 200 + 10 + 1 = 70.33 3 If Stock C doubles in price to $2, the price-weighted 100+10+2 index value is: = 37.33 3 If Stock A doubles in value, the index goes up 33.33 points, while if Stock C doubles in value, the index only goes up 0.33 points. Changes in the value of the firm with the highest stock price have a disproportionately large influence on a price-weighted index. For a market capitalization-weighted index, the base period market capitalization (100,000 x $100) + (1,000,000 x $10) + (20,000,000 x $1) = $40,000,000. is If Stock A doubles in price to $200, the index goes to: 100,000 X $200 + 1,000,000 X $10 + 20,000,000 X $1 X 100 = 125 $40,000,000 If Stock C doubles in price to $2, the index goes to: 100,000 X $100 + 1,000,000 X $10 + 20,000,000 X $2 X 100 = 150 $40,000,000 In the market capitalization-weighted index, the returns on Stock C have the greatest influence on the index return because Stock C's market capitalization is larger than that of Stock A or Stock B. utqnlihgeaWE Equal Weighting An equal-weighted index places an equal weight on the returns of all index stocks, regardless of their prices or market values. A $2 change in the price of a $20 stock has the same effect on the index as a $30 change in the price of a $300 stock regardless of the size of the company. The return of an equal-weighted index over a given period is often calculated as a simple average of the returns of the index stocks. ©20 15 Kaplan, Inc. Page 235 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #47 - Security Market Indices Example: Equally weighted index Calculate the equal-weighted index value for the three stocks described below, assuming an initial index value of 131. Equal-Weighted Index Data utrponmlkihgecaVSPICA Stock Initial Price Current Price Price Change A $12 $15 +25.00/0B B $52 $48 -7.7% C $38 $45 +18.40/0 Answer: change in index = 25% -7.70/0 + 18.40/0 = 11.90/0 3 new index value = 131 (1 + 0.119) = 146.59 Note that for a total return index, period returns would include any dividends paid over the period. LOS 47 .f: Describe rebalancing and reconstitution of an index. CPA ® Program Curriculum, Volume 5, page 91 Rebalancing refers to adjusting the weights of securities in a portfolio to their target weights after price changes have affected the weights. For index calculations, rebalancing to target weights on the index securities is done on a periodic basis, usually quarterly. Because the weights in price- and value-weighted indexes (portfolios) are adjusted to their correct values by changes in prices, rebalancing is an issue primarily for equalweighted indexes. As noted previously, the weights on security returns in an (initially) equal-weighted portfolio are not equal as securities prices change over time. Therefore, rebalancing the portfolio at the end of each period used to calculate index returns is necessary for the portfolio return to match the index return. Index reconstitution refers to periodically adding and deleting securities that make up an index. Securities are deleted if they no longer meet the index criteria and are replaced by other securities that do. Indexes are reconstituted to reflect corporate events such as bankruptcy or delisting of index firms and are at the subjective judgment of a • committee. When a security is added to an index, its price tends to rise as portfolio managers seeking to track that index in a portfolio buy the security. The prices of deleted securities tend to fall as portfolio managers sell them. Note that additions and deletions also require that the weights on the returns of other index stocks be adjusted to conform to the desired weighting scheme. Page 236 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #47 - Security Market Indices LOS 47.g: Describe uses of security market indices. xwutsrponmlkjihgfedcbaVRPMFCBA CFA® Program Curriculum, Volume 5, page 93 Security market indexes have several uses: • • • • • Reflection of market sentiment. Indexes provide a representative market return and thus reflect investor confidence. Although the Dow Jones Industrial Average is a popular index, it reflects the performance of only 30 stocks and thus may not be a good measure of sentiment with regard to the broader market. Benchmark of manager performance. An index can be used to evaluate the performance of an active manager. Because portfolio performance depends to a large degree on its chosen style, the benchmark should be consistent with the manager's investment approach and style to assess the manager's skill accurately. The index stocks should be those that the manager will actually choose from. For example, a value manager should be compared against a value index, not a broad market index, because portfolio securities will be selected from among value stocks. Measure of market return and risk.In asset allocation, estimates of the expected return and standard deviation of returns for various asset classes are based on historical returns for an index of securities representing that asset class. Measure of beta and risk-adjusted return. The use of the capital asset pricing model (CAPM) to determine a stock's expected return requires an estimate of its beta and the return on the market. Index portfolio returns are used as a proxy for the returns on the market portfolio, both in estimating a stock's beta, and then again in calculating its expected return based on its systematic (beta) risk. Expected returns can then be compared to actual stock returns to determine systematic risk-adjusted returns. Model portfolio for index funds. Investors who wish to invest passively can invest in an index fund, which seeks to replicate the performance of a market index. There are index mutual funds and index exchange-traded funds, as well as private portfolios that are structured to match the return of an index. nA LOS 47 .h: Describe types of equity indices. CFA® Program Curriculum, Volume 5, page 95 Investors can use a variety of equity market indexes. These equity indexes can be classified as follows: • • • Broad market index. Provides a measure of a market's overall performance and usually contains more than 900/0 of the market's total value. For example, the Wilshire 5000 Index contains more than 6,000 equity securities and is, therefore, a good representation of the overall performance of the u.S. equity market. Multi-market index. Typically constructed from the indexes of markets in several countries and is used to measure the equity returns of a geographic region (e.g., Latin America indexes), markets based on their stage of economic development (e.g., emerging markets indexes), or the entire world (e.g., MSCI World Index). Multi-market index with fundamental weighting. Uses market capitalizationweighting for the country indexes but then weights the country index returns in the global index by a fundamental factor (e.g., GDP). This prevents a country with previously high stock returns from being overweighted in a multi-market index. ©20 15 Kaplan, Inc. Page 237 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #47 - Security Market IndicesyxvutsrqponmlkigfedcaVSPLDCA • • Sector index. Measures the returns for an industry sector such as health care, financial, or consumer goods firms. Investors can use these indexes in cyclical analysis because some sectors do better than others in various phases of the business cycle. Sector indexes can be for a particular country or global. These indexes are used to evaluate portfolio managers and to construct index portfolios. Style index. Measures the returns to market capitalization and value or growth strategies. Some indexes reflect a combination of the two (e.g., small-cap value fund). Because there is no widely accepted definition of large-cap, mid-cap, or small-cap stocks, different indexes use different definitions. These definitions may be specified values of market capitalization or relative definitions, such as defining large-cap stocks as the largest 500 firms in a given market. In constructing value stock and growth stock indexes, price-to-earnings ratios or dividend yields are often used to identify value and growth stocks. Over time, stocks can migrate from one classification to another. For example, a successful small-cap company might grow to become a mid-cap or large-cap company. This causes style indexes to typically have higher turnover of constituent firms than broad market indexes. LOS 47 .i: Describe types of fixed-income indices. CPA ® Program Curriculum, Volume 5, page 98 Fixed income securities vary widely with respect to their coupon rates, ratings, maturities, and embedded options such as convertibility to common stock. Consequently, a wide variety of fixed income indexes is available. Like equity indexes, fixed income indexes are created for various sectors, geographic regions, and levels of country economic development. They can also be constructed based on type of issuer or collateral, coupon, maturity, default risk, or inflation protection. Broad market indexes, sector indexes, style indexes, and other specialized indexes are available. Investors should be aware of several issues with the construction of fixed income indexes: • • Large universe ofsecurities. The fixed income security universe is much broader than the universe of stocks. Fixed income securities are issued not just by firms, but also by governments and government agencies. Each of these entities may also issue various types of fixed income securities. Also, unlike stocks, bonds mature and must be replaced in fixed income indexes. As a result, turnover is high in fixed income indexes. Dealer markets and infrequent trading. Fixed income securities are primarily traded by dealers, so index providers must depend on dealers for recent prices. Because fixed income securities are typically illiquid, a lack of recent trades may require index providers to estimate the value of index securities from recent prices of securities with similar characteristics. The large number of fixed income securities results in large differences in the number of index securities among fixed income indexes. Illiquidity, transactions costs, and high turnover of constituent securities make it both difficult and expensive for fixed income portfolio managers to replicate a fixed income index. Page 238 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #47 - Security Market Indices LOS 47.j: Describe indices representing alternative investments. j vutsrponmlihgedcaWVPFCA CFA® Program Curriculum, Volume 5, page 101 Alternative assets are of interest to investors because of their potential diversification benefits. Three of the most widely held alternative assets are commodities, real estate, and hedge funds. Commodity indexes represent futures contracts on commodities such as grains, livestock, metals, and energy. Examples include the Commodity Research Bureau Index and the S&P GSCI (previously the Goldman Sachs Commodity Index). The issues in commodity indexes relevant for investors are as follows: • • Weighting method. Commodity index providers use a variety of weighting schemes. Some use equal weighting, others weight commodities by their global production values, and others use fixed weights that the index provider determines. & a result, different indexes have significantly different commodity exposures and risk and return characteristics. For example, one index may have a large exposure to the prices of energy commodities while another has a large exposure to the prices of agricultural products. Futures vs. actual. Commodity indexes are based on the prices of commodity futures contracts, not the spot prices of commodities. Commodity futures contracts reflect the risk-free rate of return, changes in futures prices, and the roll yield. Furthermore, the contracts mature and must be replaced over time by other contracts. For these reasons, the return on commodity futures differs from the returns on a long position in the commodity itself. Real estate indexes can be constructed using returns based on appraisals of properties, repeat property sales, or the performance of Real Estate Investment Trusts (REITs). REITs are similar to closed-end mutual funds in that they invest in properties or mortgages and then issue ownership interests in the pool of assets to investors. While real properties are quite illiquid, REIT shares trade like any common shares and many offer very good liquidity to investors. FTSE International produces a family of REIT indexes. Hedge funds pool investor money and invest in nontraditional assets, using leverage (borrowed money or derivative contracts) and both long and short positions. Most hedge fund indexes equally weight the returns of the hedge funds included in the index. Hedge funds are largely unregulated and are not required to report their performance to index providers. Consequently, some funds will report to one index but not another. The performance of different indexes can thus vary substantially. Furthermore, it is often the case that those funds that report are the funds that have been successful, as the poorly performing funds do not want to publicize their performance. Funds that have reported in the past but have recently had poor returns may stop reporting their performance. The result is an upward bias in index returns, with hedge funds appearing to be better investments than they actually are. ©20 15 Kaplan, Inc. Page 239 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #47 - Security Market IndicesyxvutsrponmlihgfedcbaWVSRPNMICA Professor's Note: Commodities (including the components of return on a commodity investment), real estate, and hedge funds (including hedge fund performance biases) are discussed further in the Study Session on alternative investments. LOS 47 .k: Compare types of security market indices. CPA ® Program Curriculum, Volume 5, page 103 The following table summarizes some of the noteworthy characteristics of various global indexes. Notice from the table that most security market indexes are market capitalization-weighted and often adjusted for the float (securities actually available for purchase). The number of securities in many of these indexes can vary. Index Dow Jones Industrial Average Nikkei Stock Average TOPIX Reflects Large U.S. stocks Large Japanese stocks Weighting Method Notes Price Stocks are chosen by Wall Street Journal editors Modified price Contains some illiquid stocks, price weighting and adjusted for high-priced shares Variable Market capitalization, adjusted for float Has a large number of small illiquid stocks making it hard to replicate. Contains 930/0 of the market cap of Japanese equities Variable Market capitalization, adjusted for float Available in both U.S. dollars and local currency Variable Market capitalization, adjusted for float Is the model portfolio for an ETF 30 225 All stocks on the Tokyo Stock Exchange First Section MSCI All Country World Index S&P Developed Ex-U.S. BMI Energy Sector Index Barclays Capital Global Aggregate Bond Index Global energy stocks outside the United States Markit iBoxx Euro High-Yield Bond Indexes Below investment-grade bonds FTSERPIEA EPRAI NAREIT Global Real Estate Index Page 240 Number of Constituent Securities Stocks in 23 developed and 22 emerging markets Global investment-grade bonds Global real estate Variable Market capitalization Variable Market capitalization 335 Market capitalization, adjusted for float ©2015 Kaplan, Inc. Formerly compiled by Lehman Brothers Represents liquid portion of market and rebalanced monthly Represents publicly traded REITs Study Session 13 Cross- Reference to CFA Institute Assigned Reading #47 - Security Market IndicesxutsronmlihgfedcbW Index HFRX Global Hedge Fund Index HFRXEqual Weighted Strategies EUR Index Morningstar Style Indexes Reflects Global hedge funds Global hedge funds U.S. stocks grouped by value/ growth and market cap Number of Constituent Securities Variable Variable Variable ©20 15 Kaplan, Inc. Weighting Method Notes Asset weighted Contains a variety of hedge fund strategies and is weighted based on the amount invested in each hedge fund Equal weighted Contains same strategy funds as HFRX Global Hedge Fund Index and is equal weighted Market capitalization, adjusted for float Nine categories classified by combinations of three cap categories and three value/growth • categories Page 241 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #47 - Security Market Indices LOS 47.a A security market index represents the performance of an asset class, security market, or segment of a market. The performance of the market or segment over a period of time is represented by the percentage change in (i.e., the return on) the value of the index. LOS 47.h A price index uses only the prices of the constituent The rate of return is called a price return. securities in the return calculation. A total return index uses both the price of and the income from the index securities in the return calculation. LOS 47.c Decisions that index providers must make when constructing and managing indexes include: • The target market the index will measure. • Which securities from the target market to include. • The appropriate weighting method. • How frequently to rebalance the index to its target weights. • How frequently to re-examine the selection and weighting of securities. LOS 47.d A price-weighted index is the arithmetic mean of the prices of the index securities. The divisor, which is initially equal to the number of securities in the index, must be adjusted for stock splits and changes in the composition of the index over time. An equal-weighted index assigns the same weight to each of its constituent securities. A market capitalization-weighted index gives each constituent security a weight equal to its proportion of the total market value of all securities in the index. Market capitalization can be adjusted for a security's market float or free float to reflect the fact that not all outstanding shares are available for purchase. A fundamental-weighted index uses weights that are independent as company earnings, revenue, assets, or cash flow. of security prices, such LOS 47.e . . h d i d P rice-weig te In ex = xiXI sum of stock prices . number of stocks in index adjusted for splits Market capitalization-weighted index = current total market value of index stocks ------------------ X b . d I ase year In ex va ue. base year total market value of index stocks Equal-weighted index = (1 + average percentage change in index stocks) x initial index value. Page 242 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #47 - Security Market Indices LOS 47.f Index providers periodically rebalance the weights of the constituent securities. This is most important for equal-weighted indexes. Reconstitution refers to changing the securities that are included in an index. This is necessary when securities mature or when they no longer have the required characteristics to be included. LOS 47.g Indexes are used for the following purposes: • Reflection of market sentiment. • Benchmark of manager performance. • Measure of market return. • Measure of beta and excess return. • Model portfolio for index funds. LOS 47.h Broad market equity indexes represent the majority of stocks in a market. Multi-market equity indexes contain the indexes of several countries. Multi-market equity indexes with fundamental weighting use market capitalization weighting for the securities within a country's market but then weight the countries within the global index by a fundamental factor. Sector indexes measure the returns for a sector (e.g., health care) and are useful because some sectors do better than others in certain business cycle phases. These indexes are used to evaluate portfolio managers and as models for sector investment funds. Style indexes measure the returns to market capitalization and value or growth strategies. Stocks tend to migrate among classifications, which causes style indexes to have higher constituent turnover than broad market indexes. LOS 47.i Fixed income indexes can be classified by issuer, collateral, coupon, maturity, credit risk (e.g., investment grade versus high-yield), and inflation protection. They can be delineated as broad market, sector, style, or other specialized indexes. Indexes exist for various sectors, regions, and levels of development. The fixed income security universe is much broader than the equity universe, and fixed income indexes have higher turnover. Index providers must depend on dealers for fixed income security prices, and the securities are often illiquid. Fixed income security indexes vary widely in their numbers of constituent securities and can be difficult and expensive to replicate. ©20 15 Kaplan, Inc. Page 243 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #47 - Security Market Indices LOS 47.j Indexes have been developed to represent markets for alternative assets such as commodities, real estate, and hedge funds. Issues in creating commodity indexes include the weighting method (different indexes can have vastly different commodity weights and resulting risk and return) and the fact that commodity indexes are based on the performance of commodity futures contracts, not the actual commodities, which can result in different performance for a commodity index versus the actual commodity. Real estate indexes include appraisal indexes, repeat property sales indexes, and indexes of real estate investment trusts. Because hedge funds report their performance to index providers voluntarily, the performance of different hedge fund indexes can vary substantially and index returns have an upward bias. LOS 47.k Security market indexes available from commercial providers represent a variety of asset classes and reflect target markets that can be classified by: • Geographic location, such as country, regional, or globalindexes. • Sector or industry, such as indexes of energy producers. • Level of economic development, such as emerging market indexes. • Fundamental factors, such as indexes of value stocks or growth stocks. Page 244 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #47 - Security Market Indices Use the information in the following table to answer Questions 1 through 3. As of December 31 As of January 1 Share Price Number of Shares Outstanding (thousands) Share Price Number of Shares Outstanding (thousands) Stock A $22 1,500 $28 1,500 Stock B $40 10,000 $50 10,000 Stock C $34 3,000yutsronmlkihgfedcbaSPONJDA$30 3,000 nCBA 1. The I-year return on a price-weighted index of these three stocks is closest to: A. 12.50/0. B. 13.50/0. C. 18.00/0. 2. The I-year return on an equal-weighted index of these three stocks is closest to: A. 12.0%. B. 12.50/0. C. 13.50/0. 3. The I-year return on a market capitalization-weighted closest to: A. 12.50/0. B. 13.50/0. C. 18.00/0. 4. Market float of a stock is best described as its: A. total outstanding shares. B. shares that are available to domestic investors. C. outstanding shares excluding those held by controlling shareholders. 5. For A. B. C. 6. Which of the following would most likely represent an inappropriate use of an index? A. As a reflection of market sentiment. B. Comparing a small-cap manager against a broad market. C. Using the CAPM to determine the expected return and beta. index of these stocks is which of the following indexes will rebalancing occur most frequently? A price-weighted index. An equal-weighted index. A market capitalization-weighted index. ©20 15 Kaplan, Inc. Page 245 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #47 - Security Market Indices 7. Which of the following is least accurate regarding fixed income indexes? A. Replicating the return on a fixed income security index is difficult for • Investors. B. There is a great deal of heterogeneity in the composition of fixed income security indexes. c. Due to the large universe of fixed income security issues, data for fixed income securities are relatively easy to obtain. utsrleca c 8. Page 246 Most of the widely used global security indexes are: A. price-weighted. B. equal-weighted. C. market capitalization-weighted. ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #47 - Security Market Indices 1. 2. 3. A C C 22+40+34 3 28 --1 22 = 32 28+50+30 ' 3 50 + --1 40 30 + --1 34 =36 1 3 36 -1=0.125=12.5% ' 32 = 0.135 = 13.50/0 Total portfolio value January 1: 22(1,500) + 40(10,000) + 34(3,000) = $535,000 Total portfolio value December 31: 28(1,500) + 50(10,000) + 30(3,000) = $632,000 632 -1 = 0.1813 ~ 18% 535 From a base value of 100, the December 31 index value would be 632 x l 00 = 118.13. 535 4. C Market float represents shares available to the investing public and excludes shares held by controlling shareholders. Free float is a narrower measure that also excludes shares that are not available to foreign investors. 5. B An equal-weighted index will be rebalanced most frequently because as stock prices change, their representation in the index needs to be adjusted. Price-weighted and market capitalization-weighted indexes do not usually need rebalancing. 6. B Comparing a small-cap manager against a broad market would be an inappropriate use of an index. A benchmark should be consistent with the manager's investment approach and style. A manager's performance will depend to a large degree on its chosen style. 7. C Fixed income securities are largely traded by dealers and trade infrequently. Data are therefore difficult to obtain. 8. C Most global security indexes are market capitalization-weighted to reflect the amount of shares available to investors. ©20 15 Kaplan, Inc. with a float adjustment Page 247 The following is a review of the Equity: Market Organization, Market Indices, and Market Efficiency principles designed to address the learning outcome statements set forth by CFA Institute. CrossReference to CFA Institute Assigned Reading #48.YTRNMKIFECA MARKET EFFICIENCY Study Session 13nXMEA EXAM Focus The informational efficiency of market prices is a very important concept to a portfolio manager. When markets are truly efficient, careful analysis and security selection using publicly available information will not lead to positive risk-adjusted returns on average. For the exam, you must understand the three forms of market efficiency and know the evidence from tests of each form of market efficiency. Focus your attention on the implications of this evidence about the value of technical and fundamental analysis and about the role of portfolio managers in the investment process. Finally, be familiar with market anomalies listed and the perspective provided by behavioral finance. LOS 48.a: Describe market efficiency and related concepts, including their • • • • Importance to Investment practrnoners. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 117 An informationally efficient capital market is one in which the current price of a security fully, quickly, and rationally reflects all available information about that security. This is really a statistical concept. An academic might say, "Given all available information, current securities prices are unbiased estimates of their values, so that the expected return on any security is just the equilibrium return necessary to compensate investors for the risk (uncertainty) regarding its future cash flows." This concept is often put more intuitively as, "You can't beat the market." In a perfectly efficient market, investors should use a passive investment strategy (i.e., buying a broad market index of stocks and holding it) because active investment strategies will underperform due to transactions costs and management fees. However, to the extent that market prices are inefficient, active investment strategies can generate positive risk-adjusted returns. One method of measuring a market's efficiency is to determine the time it takes for trading activity to cause information to be reflected in security prices (i.e., the lag from the time information is disseminated to the time prices reflect the value implications of that information). In some very efficient markets, such as foreign currency markets, this lag can be as short as a minute. If there is a significant lag, informed traders can use the information to potentially generate positive risk-adjusted returns. Note that market prices should not be affected by the release of information that is well anticipated. Only new information (information that is unexpected and changes expectations) should move prices. The announcement that a firm's earnings were up 450/0 over the last quarter may be good news if the expected increase was 200/0. On the other Page 248 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #48 - Market Efficiency hand, this may be bad news if a 700/0 increase was anticipated or no news at all if market participants correctly anticipated quarterly earnings. LOS 48.b: Distinguish between market value and intrinsic value. urpomligecaVPFCA CFA® Program Curriculum, Volume 5, page 119 The market value of an asset is its current price. The intrinsic value or fundamental value of an asset is the value that a rational investor with full knowledge about the asset's characteristics would willingly pay. For example, a bond investor would fully know and understand a bond's coupon, maturity, default risk, liquidity, and other characteristics and would use these to estimate its intrinsic value. In markets that are highly efficient, investors can typically expect market values to reflect intrinsic values. If markets are not completely efficient, active managers will buy assets for which they think intrinsic values are greater than market values and sell assets for which they think intrinsic values are less than market values. Intrinsic values cannot be known with certainty and are estimated by investors who will have differing estimates of an asset's intrinsic value. The more complex an asset, the more difficult it is to estimate its intrinsic value. Furthermore, intrinsic value is constantly changing as new (unexpected) information becomes available. LOS 48.c: Explain factors that affect a market's efficiency. CFA ® Program Curriculum, Volume 5, page 120 Markets are generally neither perfectly efficient nor completely inefficient. The degree of informational efficiency varies across countries, time, and market types. The following factors affect the degree of market efficiency. Number of market participants. The larger the number of investors, analysts, and traders who follow an asset market, the more efficient the market. The number of participants can vary through time and across countries. For example, some countries prevent foreigners from trading in their markets, reducing market efficiency. Availability of information. The more information is available to investors, the more efficient the market. In large, developed markets such as the New York Stock Exchange, information is plentiful and markets are quite efficient. In emerging markets, the availability of information is lower, and consequently, market prices are relatively less efficient. Some assets, such as bonds, currencies, swaps, forwards, mortgages, and money market securities that trade in over-the-counter (OTC) markets, may have less available information. Access to information should not favor one party over another. Therefore, regulations such as the u.S. Securities and Exchange Commission's Regulation FD (fair disclosure) require that firms disclose the same information to the public that they disclose to stock ©20 15 Kaplan, Inc. Page 249 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #48 - Market Efficiency analysts. Traders with material inside information about a firm are prohibited from trading on that information. Impediments to trading. Arbitrage refers to buying an asset in one market and simultaneously selling it at a higher price in another market. This buying and selling of assets will continue until the prices in the two markets are equal. Impediments to arbitrage, such as high transactions costs or lack of information, will limit arbitrage activity and allow some price inefficiencies (i.e., mispricing of assets) to persist. Short selling improves market efficiency. The sales pressure from short selling prevents assets from becoming overvalued. Restrictions on short selling, such as an inability to borrow stock cheaply, can reduce market efficiency. Transaction and information costs. To the extent that the costs of information, analysis, and trading are greater than the potential profit from trading misvalued securities, market prices will be inefficient. It is generally accepted that markets are efficient if, after deducting costs, there are no risk-adjusted returns to be made from trading based on publicly available information. LOS 48.d: Contrast weak-form, semi-strong-form, efficiency. and strong-form market yvutsrponmlkihgfedcbaVPFCA CFA® Program Curriculum, Volume 5, page 124 Professor Eugene Fama originally developed the concept of market efficiency and identified three forms of market efficiency. The difference among them is that each is based on a different set of information. 1. Weak-form market efficiency. The weak form of the efficient markets hypothesis (EM H) states that current security prices fully reflect all currently available security market data. Thus, past price and volume (market) information will have no predictive power about the future direction of security prices because price changes will be independent from one period to the next. In a weak-form efficient market, an investor cannot achieve positive risk-adjusted returns on average by using technical analysis. Page 250 2. Semi-strong form market efficiency. The semi-strong form of the EMH holds that security prices rapidly adjust without bias to the arrival of all new public information. As such, current security prices fully reflect all publicly available information. The semi-strong form says security prices include all past security market information and nonmarket information available to the public. The implication is that an investor cannot achieve positive risk-adjusted returns on average by using fundamental analysis. 3. Strong-form market efficiency. The strong form of the EMH states that security prices fully reflect all information from both public and private sources. The strong form includes all types of information: past security market information, public, and private (inside) information. This means that no group of investors has monopolistic access to information relevant to the formation of prices, and none should be able to consistently achieve positive abnormal returns. ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #48 - Market Efficiency Given the prohibition on insider trading in most markets, it would be unrealistic to expect markets to reflect all private information. The evidence supports the view that markets are not strong-form efficient. ywvutsrponmlkihgfedcbaVPNMHFECA Professor's Note: As a base level knowledge of the EMH, you should know that the weak form is based on past security market information; the semi-strong form is based on all public information (including market information); and the strong form is based on both public information and inside or private information. LOS 48.e: Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management. CFA® Program Curriculum, Volume 5, page 128 Abnormal profit (or risk-adjusted returns) calculations are often used to test market efficiency. To calculate abnormal profits, the expected return for a trading strategy is calculated given its risk, using a model of expected returns such as the CAPM or a multifactor model. If returns are, on average, greater than equilibrium expected returns, we can reject the hypothesis of efficient prices with respect to the information on which the strategy is based. The results of tests of the various forms of market efficiency have implications about the value of technical analysis, fundamental analysis, and portfolio management in general. Technical analysis seeks to earn positive risk-adjusted returns by using historical price and volume (trading) data. Tests of weak-form market efficiency have examined whether technical analysis produces abnormal profits. Generally, the evidence indicates that technical analysis does not produce abnormal profits, so we cannot reject the hypothesis that markets are weak-form efficient. However, technical analysis has been shown to have success in emerging markets, and there are so many possible technical analysis trading strategies that they cannot all be tested. As noted previously, the success of any technical analysis strategy should be evaluated considering the costs of information, analysis, and trading. Fundamental analysis is based on public information such as earnings, dividends, and various accounting ratios and estimates. The semi-strong form of market efficiency suggests that all public information is already reflected in stock prices. As a result, investors should not be able to earn abnormal profits by trading on this information. One method of testing the semi-strong form is an event study. Event studies examine abnormal returns before and after the release of new information that affects a firm's intrinsic value, such as earnings announcements or dividend changes. The null hypothesis is that investors should not be able to earn positive abnormal returns on average by trading based on firm events because prices will rapidly reflect news about a firm's prospects. The evidence in developed markets indicates that markets are generally semi-strong form efficient. However, there is evidence of semi-strong form inefficiency in some emerging markets. ©20 15 Kaplan, Inc. Page 251 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #48 - Market Efficiency The evidence that developed markets are generally semi-strong form efficient raises questions about the usefulness of fundamental analysis. It must be fundamental analysis, however, that results in informationally efficient market prices. Fundamental analysis can also be of use to those exceptionally skilled investors who can generate abnormal profits through its use and to those who act rapidly before new information is reflected • • In prIces. ywutsrponmlkihgfedcbaVPNMFCA Professor's Note: Markets can be weak-form efficient without being semi-strong or strong-form efficient. If markets are semi-strong form efficient, they must be weak-form efficient because public information includes market information, but semi-strong form efficient markets need not be strong-form efficient. fI Active vs. Passive Portfolio Management If markets are semi-strong form efficient, investors should invest passively (i.e., invest in an index portfolio that replicates the returns on a market index). Indeed, the evidence shows that most mutual fund managers cannot outperform a passive index strategy over • time. If so, what is the role of a portfolio manager? Even if markets are efficient, portfolio managers can add value by establishing and implementing portfolio risk and return objectives and by assisting clients with portfolio diversification, asset allocation, and tax management. LOS 48.f: Describe market anomalies. CFA® Program Curriculum, Volume 5, page 129 An anomaly is something that deviates from the common rule. Tests of the EMH are frequently called anomaly studies, so in the efficient markets literature, a market anomaly is something that would lead us to reject the hypothesis of market efficiency. Just by chance, some variables will be related to abnormal returns over a given period, although in fact these relationships are unlikely to persist over time. Thus, analysts using historical data can find patterns in security returns that appear to violate market efficiency but are unlikely to recur in the future. If the analyst uses a 50/0 significance level and examines the relationship between stock returns and 40 variables, two of the variables are expected to show a statistically significant relationship with stock returns by random chance. Recall that the significance level of a hypothesis test is the probability that the null hypothesis (efficiency here) will be rejected purely by chance, even when it is true. Investigating data until a statistically significant relation is found is referred to as data mining or data snooping. Note that 1,000 analysts, each testing different hypotheses on the same data set, could produce the same results as a single researcher who performed 1,000 hypothesis tests. To avoid data-mining bias, analysts should first ask if there is an economic basis for the relationships they find between certain variables and stock returns and then test the Page 252 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #48 - Market Efficiency discovered relationships with a large sample of data to determine if the relationships are persistent and present in various subperiods. ywutsronmlkihfedcaTSDCA Anomalies in Time-Series Data Calendar anomalies. The January effect or turn-of-the-year effect is the finding that during the first five days of January, stock returns, especially for small firms, are significantly higher than they are the rest of the year. In an efficient market, traders would exploit this profit opportunity in January, and in so doing, eliminate it. Possible explanations for the January effect are tax-loss selling, as investors sell losing positions in December to realize losses for tax purposes and then repurchase stocks in January, pushing their prices up, and window dressing, as portfolio managers sell risky stocks in December to remove them from their year-end statements and repurchase them in January. Evidence indicates that each of these explains only a portion of the January effect. However, after adjustments are made for risk, the January effect does not appear • • to persIst over time. Other calendar anomalies that were found at one time but no longer appear to persist are the turn-of the-month effect (stock returns are higher in the days surrounding month end), the day-of the-week effect (average Monday returns are negative), the weekend effect (positive Friday returns are followed by negative Monday returns), and the holiday effect (pre-holiday returns are higher). Overreaction and momentum anomalies. The overreaction effect refers to the finding that firms with poor stock returns over the previous three or five years (losers) have better subsequent returns than firms that had high stock returns over the prior period. This pattern has been attributed to investor overreaction to both unexpected good news and unexpected bad news. This pattern is also present for bonds and in some international markets. Momentum effects have also been found where high shortterm returns are followed by continued high returns. This pattern is present in some international markets as well. Both the overreaction and momentum effects violate the weak form of market efficiency because they provide evidence of a profitable strategy based only on market data. Some researchers argue that the evidence of overreaction to new information is due to the nature of the statistical tests used and that evidence of momentum effects in securities prices reflects rational investor behavior. Anomalies in Cross-Sectional Data The size effect refers to initial findings that small-cap stocks outperform large-cap stocks. This effect could not be confirmed in later studies, suggesting that either investors had traded on, and thereby eliminated, this anomaly or that the initial finding was simply a random result for the time period examined. The value effect refers to the finding that value stocks [those with lower priceto-earnings (PIE), lower market-to-book (M/B), and higher dividend yields] have outperformed growth stocks (those with higher PIE, higher MIB, and lower dividend PMIEB ©20 15 Kaplan, Inc. Page 253 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #48 - Market Efficiency yields). This violates the semi-strong form of market efficiency because the information necessary to classify stocks as value or growth is publicly available. However, some researchers attribute the value effect to greater risk of value stocks that is not captured in the risk adjustment procedure used in the studies. zwvutsrponmlkihgfedcaTSPONMIA Other Anomalies Closed-end investment funds. The shares of closed-end investment funds trade at prices that sometimes deviate from the net asset value (NAV) of the fund shares, often trading at large discounts to NAY. Such large discounts are an anomaly because, by arbitrage, the value of the pool of assets should be the same as the market price for closed-end shares. Various explanations have been put forth to explain this anomaly, including management fees, taxes on future capital gains, and share illiquidity. None of these explanations fully explains the pricing discrepancy. However, transactions costs would eliminate any profits from exploiting the unexplained portion of closed-end fund discounts. Earnings announcements. An earnings surprise is that portion of announced earnings that was not expected by the market. Positive earnings surprises (earnings higher than expected) precede periods of positive risk-adjusted post-announcement stock returns, and negative surprises lead to predictable negative risk-adjusted returns. The anomaly is that the adjustment process does not occur entirely on the announcement day. Investors could exploit this anomaly by buying positive earnings surprise firms and selling negative earnings surprise firms. Some researchers argue that evidence of predictable abnormal returns after earnings surprises is a result of estimating risk-adjusted returns incorrectly in the tests and that transactions costs would eliminate any abnormal profits from attempting to exploit this returns anomaly. nA Initial public offerings. IPOs are typically underpriced, with the offer price below the market price once trading begins. However, the long-term performance of IPO shares as a group is below average. This suggests that investors overreact, in that they are too optimistic about a firm's prospects on the offer day. Some believe this is not an anomaly, but rather a result of the statistical methodologies used to estimate abnormal returns. Professor'sNote: The initial underpricing of IPOs is also discussed in the topic review of Market Organization and Structure. Economic fundamentals. Research has found that stock returns are related to known economic fundamentals such as dividend yields, stock volatility, and interest rates. However, we would expect stock returns to be related to economic fundamentals in efficient markets. The relationship between stock returns and dividend yields is also not consistent over all time periods. Implications for Investors The majority of the evidence suggests that reported anomalies are not violations of market efficiency but are due to the methodologies used in the tests of market efficiency. Furthermore, both underreaction and overreaction have been found in the markets, Page 254 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #48 - Market Efficiency meaning that prices are efficient on average. Other explanations for the evidence of anomalies are that they are transient relations, too small to profit from, or simply reflect returns to risk that the researchers have failed to account for. The bottom line for investors is that portfolio management based on previously identified anomalies will likely be unprofitable. Investment management based solely on anomalies has no sound economic basis. LOS 48.g: Describe behavioral finance and its potential relevance to understanding market anomalies. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 136 Behavioral finance examines the actual decision-making processes of investors. Many observers have concluded that investors are not the rational utility-maximizing decision makers with complete information that traditional finance assumes they are. Investors appear to exhibit bias in their decision making, base decisions on the actions of others, and not evaluate risk in the way traditional models assume they do. Various types of investor irrationality have been proposed as explanations for reported pricing anomalies. Whether widespread investor irrationality is the underlying cause of reported returns anomalies is an open question. Market efficiency does not require an assumption that every investor acts rationally in accordance with traditional finance theory. Semi-strong form market efficiency requires that investors cannot earn positive abnormal returns on average (beat the market) using public information. The evidence on market efficiency certainly suggests that this is the case. Evidence that some investors exhibit bias, or other deviations from perfect rationality, in their investment decision making does not necessarily mean that market prices themselves are irrational, at least not in ways that lead to violations of market efficiency. Observed investor behaviors and biases that are considered evidence of irrational behavior include: • • • Loss aversion, which refers to the tendency of investors tobe more risk averse when faced with potential losses than they are when faced with potential gains. Put another way, investors dislike a loss more than they like a gain of an equal amount. Investor overconfidence, which is a tendency of investors to overestimate their abilities to analyze security information and identify differences between securities' market prices and intrinsic values. Herding, which is a tendency of investors to act in concert on the same side of the market, acting not on private analysis, but mimicking the investment actions of other investors. An information cascade results when investors mimic the decisions of others. The idea is that uninformed or less-informed traders watch the actions of informed traders and follow their investment actions. If those who act first are more knowledgeable investors, others following their actions may, in fact, be part of the process of incorporating new information into securities prices and actually move market prices toward their intrinsic values, improving informational efficiency. ©20 15 Kaplan, Inc. Page 255 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #48 - Market Efficiency Behavioral finance can explain how securities' market prices can deviate from rational prices and be biased estimates of intrinsic value. If investor rationality is viewed as a prerequisite for market efficiency, then markets are not efficient. If market efficiency only requires that investors cannot consistently earn abnormal risk-adjusted returns, then research supports the belief that markets are efficient. Page 256 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #48 - Market Efficiency LOS 48.a In an informationally efficient capital market, security prices reflect all available information fully, quickly, and rationally. The more efficient a market is, the quicker its reaction will be to new information. Only unexpected information should elicit a response from traders. If the market is fully efficient, active investment strategies cannot earn positive riskadjusted returns consistently, and investors should therefore use a passive strategy. LOS 48.b An asset's market value is the price at which it can currently be bought or sold. An asset's intrinsic value is the price that investors with full knowledge of the asset's characteristics would place on the asset. LOS 48.c Large numbers of market participants and greater information availability tend to make markets more efficient. Impediments to arbitrage and short selling and high costs of trading and gathering information tend to make markets less efficient. LOS 48.d The weak form of the efficient markets hypothesis (EM H) states that security prices fully reflect all past price and volume information. The semi-strong form of the EMH states that security prices fully reflect all publicly available information. The strong form of the EMH states that security prices fully reflect all public and private information. LOS 48.e If markets are weak-form efficient, technical analysis does not consistently result in abnormal profits. If markets are semi-strong form efficient, fundamental analysis does not consistently result in abnormal profits. However, fundamental analysis is necessary if market prices are to be semi-strong form efficient. If markets are strong-form efficient, active investment management does not consistently result in abnormal profits. Even if markets are strong-form efficient, portfolio managers can add value by establishing and implementing portfolio risk and return objectives and assisting with portfolio diversification, asset allocation, and tax minimization. ©20 15 Kaplan, Inc. Page 257 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #48 - Market Efficiency LOS 48.£ A market anomaly is something that deviates from the efficient market hypothesis. Most evidence suggests anomalies are not violations of market efficiency but are due to the methodologies used in anomaly research, such as data mining or failing to adjust adequately for risk. Anomalies that have been identified in time-series data include calendar anomalies such as the January effect (small firm stock returns are higher at the beginning of January), overreaction anomalies (stock returns subsequently reverse), and momentum anomalies (high short-term returns are followed by continued high returns). Anomalies that have been identified in cross-sectional data include a size effect (smallcap stocks outperform large-cap stocks) and a value effect (value stocks outperform growth stocks). Other identified anomalies involve closed-end investment funds selling at a discount to NAV, slow adjustments to earnings surprises, investor overreaction to and long-term underperformance of lPOs, and a relationship between stock returns and prior economic fundamen tals. LOS 48.g Behavioral finance examines whether investors behave rationally, how investor behavior affects financial markets, and how cognitive biases may result in anomalies. Behavioral finance describes investor irrationality but does not necessarily refute market efficiency as long as investors cannot consistently earn abnormal risk-adjusted returns. Page 258 ©2015 Kaplan, Inc. Study Session 13 Cross- Reference to CFA Institute Assigned Reading #48 - Market Efficiency 1. In A. B. C. an informationally efficient capital market: active managers can generate abnormal profits. security prices quickly reflect new information. investors react to all information releases rapidly. 2. In terms of market efficiency, short selling most likely: A. leads to excess volatility, which reduces market efficiency. B. promotes market efficiency by making assets less likely to become overvalued. C. has little effect on market efficiency because short sellers face the risk of unlimited losses. 3. The intrinsic value of an asset: A. changes through time as new information is released. B. is the price at which the asset can be bought or sold at a given point in time. C. can be easily determined with a financial calculator, given investor risk preferences. 4. The weak-form EMH asserts that stock prices fully reflect which of the following types of information? A. Market only. B. Market and public. C. Public and private. 5. Research has revealed that the performance of professional money managers tends to be: A. equal to the performance of a passive investment strategy. B. inferior to the performance of a passive investment strategy. C. superior to the performance of a passive investment strategy. 6. Which of the following best describes the majority of the evidence regarding anomalies in stock returns? A. Weak-form market efficiency holds but semi-strong form efficiency does not. B. Neither weak-form nor semi-strong form market efficiency holds. C. Reported anomalies are not violations of market efficiency but are the result of research methodologies. 7. Investors who exhibit loss aversion most likely: A. have symmetric risk preferences. B. are highly risk averse. C. dislike losses more than they like equal gains. ytsomlkieb ©20 15 Kaplan, Inc. Page 259 Study Session 13 Cross-Reference to CFA Institute Assigned Reading #48 - Market Efficiency Page 260 1. B In informationally efficient capital markets, new information is quickly reflected in security prices. Investors react only to unexpected information releases because information releases that are expected will already be reflected in securities prices. Active strategies will underperform in an efficient market because they have greater transactions and management costs than passive strategies and will not consistently create positive abnormal returns after adjusting for risk. 2. B Short selling promotes market efficiency because the sales pressure from short selling can reduce the prices of assets that have become overvalued. 3. A Intrinsic value changes as new information arrives in the marketplace. It cannot be known with certainty and can only be estimated. The price of an asset at a given point in time is its market value, which will differ from its intrinsic value if markets are not fully efficient. 4. A Weak-form EMH states that stock prices fully reflect all market (i.e., price and volume) information. 5. B Tests indicate that mutual fund performance has been inferior to that of a passive index strategy. 6. C The majority of evidence is that anomalies are not violations of market efficiency but are due to the research methodologies used. Portfolio management based on anomalies will likely be unprofitable after transactions costs are considered. 7. C Loss aversion refers to the tendency of investors to be more risk averse when faced with potential losses and less risk averse when faced with potential gains. That is, they dislike losses more than they like gains of an equal amount. Their risk preferences are • asymmetric. ©2015 Kaplan, Inc. The following is a review of the Equity Analysis and Valuation principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #49.YWVUTSRQOIEC OVERVIEW" OF EQUITY SECURITIES OF Study Session 14XMEA EXAM Focus Equities have higher returns than bonds and bills, but also higher risk. Know the characteristics of common and preferred equity types, as well as the methods of investing in foreign stock. Understand the difference between the book value of equity and market value of equity and what this difference represents. LOS 49.a: Describe characteristics of types of equity securities. urpomligecaVPFCA CFA® Program Curriculum, Volume 5, page 155 Common shares are the most common form of equity and represent an ownership interest. Common shareholders have a residual claim (after the claims of debtholders and preferred stockholders) on firm assets if the firm is liquidated and govern the corporation through voting rights. Firms are under no obligation to pay dividends on common equity; the firm determines what dividend will be paid periodically. Common stockholders are able to vote for the board of directors, on merger decisions, and on the selection of auditors. If they are unable to attend the annual meeting, shareholders can vote by proxy (having someone else vote as they direct them, on their behalf). In a statutory voting system, each share held is assigned one vote in the election of each member of the board of directors. Under cumulative voting, shareholders can allocate their votes to one or more candidates as they choose. For example, consider a situation where a shareholder has 100 shares and three directors will be elected. Under statutory voting, the shareholder can vote 100 shares for his director choice in each election. Under cumulative voting, the shareholder has 300 votes, which can be cast for a single candidate or spread across multiple candidates. The three receiving the greatest number of votes are elected. Cumulative voting makes it possible for a minority shareholder to have more proportional representation on the board. The way the math works, a holder of 300/0 of the firm's shares could choose three of ten directors with cumulative voting but could elect no directors under statutory voting. Callable common shares give the firm the right to repurchase the stock at a pre-specified call price. Investors receive a fixed amount when the firm calls the stock. The call feature benefits the firm because when the stock's market price is greater than the call price, the firm can call the shares and reissue them later at a higher price. Calling the shares, similarly to the repurchase of shares, allows the firm to reduce its dividend payments without changing its per-share dividend. Putable common shares give the shareholder the right to sell the shares back to the firm at a specific price. A put option on the shares benefits the shareholder because it ©20 15 Kaplan, Inc. Page 261 Study Session 14 Cross- Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities effectively places a floor under the share value. Shareholders pay for the put option because other things equal, putable shares are sold for higher prices than non-putable shares and raise more capital for the firm when they are issued. Preference shares (or preferred stock) have features of both common stock and debt. As with common stock, preferred stock dividends are not a contractual obligation, the shares usually do not mature, and the shares can have put or call features. Like debt, preferred shares typically make fixed periodic payments to investors and do not usually have voting rights. Cumulative preference shares are usually promised fixed dividends, and any dividends that are not paid must be made up before common shareholders can receive dividends. The dividends of non-cumulative preference shares do not accumulate over time when they are not paid, but dividends for any period must be paid before common shareholders can receive dividends. Preferred shares have a stated par value and pay a percentage dividend based on the par value of the shares. An $80 par value preferred with a 100/0 dividend pays a dividend of $8 per year. Investors in participating preference shares receive extra dividends if firm profits exceed a predetermined level and may receive a value greater than the par value of the preferred stock if the firm is liquidated. Non-participating preference shares have a claim equal to par value in the event of liquidation and do not share in firm profits. Smaller and riskier firms whose investors may be concerned about the firm's future often issue participating preferred stock so investors can share in the upside potential of the firm. nA Convertible preference shares can be exchanged for common stock at a conversion ratio determined when the shares are originally issued. It has the following advantages: • • • • The preferred dividend is higher than a common dividend. If the firm is profitable, the investor can share in the profits by converting his shares into common stock. The conversion option becomes more valuable when the common stock price • Increases. Preferred shares have less risk than common shares because the dividend is stable and they have priority over common stock in receiving dividends and in the event of liquidation of the firm. Because of their upside potential, convertible preferred shares are often used to finance risky venture capital and private equity firms. The conversion feature compensates investors for the additional risk they take when investing in such firms. LOS 49.b: Describe differences in voting rights and other ownership characteristics among different equity classes. urpomligecaVPFCA CFA® Program Curriculum, Volume 5, page 156 A firm may have different classes of common stock (e.g., "Class A" and "Class B" shares). One class may have greater voting power and seniority if the firm's assets are liquidated. The classes may also be treated differently with respect to dividends, stock Page 262 ©2015 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities splits, and other transactions with shareholders. Information on the ownership and voting rights of different classes of equity shares can be found in the company's filings with securities regulators, such as the Securities and Exchange Commission in the United States. LOS 49.c: Distinguish between public and private equity securities. zyutsrponmligedcaVPCA CPA ® Program Curriculum, Volume 5, page 162 The discussion so far has centered on equity that is publicly traded. Private equity is usually issued to institutional investors via private placements. Private equity markets are smaller than public markets but are growing rapidly. Compared to public equity, private equity has the following characteristics: • • • • • • • Less liquidity because no public market for the shares exists. Share price is negotiated between the firm and its investors, not determined in a market. More limited firm financial disclosure because there is nogovernment or exchange requirement to do so. Lower reporting costs because of less onerous reporting requirements. Potentially weaker corporate governance because of reduced reporting requirements and less public scrutiny. Greater ability to focus on long-term prospects because there is no public pressure for short-term results. Potentially greater return for investors once the firm goes public. The three main types of private equity investments are venture capital, leveraged buyouts, and private investments in public equity. Venture capital refers to the capital provided to firms early in their life cycles to fund their development and growth. Venture capital financing at various stages of a firm's development is referred to as seed or start-up, early stage, or mezzanine financing. Investors can be family, friends, wealthy individuals, or private equity funds. Venture capital investments are illiquid and investors often have to commit funds for three to ten years before they can cash out (exit) their investment. Investors hope to profit when they can sell their shares after (or as part of) an initial public offering or to an established firm. In a leveraged buyout (LBO), investors buy all of a firm's equity using debt financing (leverage). If the buyers are the firm's current management, the LBO is referred to as a management buyout (MBO). Firms in LBOs usually have cash flow that is adequate to service the issued debt or have undervalued assets that can be sold to pay down the debt • over time. In a private investment in public equity (PIPE), a public firm that needs capital quickly sells private equity to investors. The firm may have growth opportunities, be in distress, or have large amounts of debt. The investors can often buy the stock at a sizeable discount to its market price. ©20 15 Kaplan, Inc. Page 263 Study Session 14 Cross- Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities LOS 49.d: Describe methods for investing in non-domestic equity securities. utrponmligedcaVPCA CPA ® Program Curriculum, Volume 5, page 164 When capital flows freely across borders, markets are said to be integrated. The world's financial markets have become more integrated over time, especially as a result of improved communications and trading technologies. However, barriers to global capital flows still exist. Some countries restrict foreign ownership of their domestic stocks, primarily to prevent foreign control of domestic companies and to reduce the variability of capital flows in and out of their countries. An increasing number of countries have dropped foreign capital restrictions. Studies have shown that reducing capital barriers improves equity market performance. Furthermore, companies are increasingly turning to foreign investors for capital by listing their stocks on foreign stock exchanges or by encouraging foreign ownership of shares. From the firm's perspective, listing on foreign stock exchanges increases publicity for the firm's products and the liquidity of the firm's shares. Foreign listing also increases firm transparency due to the stricter disclosure requirements of many foreign markets. Direct investing in the securities of foreign companies simply refers to buying a foreign firm's securities in foreign markets. Some obstacles to direct foreign investment are that: • • • • The investment and return are denominated in a foreign currency. The foreign stock exchange may be illiquid. The reporting requirements of foreign stock exchanges maybe less strict, impeding analysis. Investors must be familiar with the regulations and procedures of each market in which they invest. Other methods for investing in foreign companies are provided by global depository receipts (GDRs), American depository receipts (ADRs), global registered shares (GRSs), and baskets of listed depository receipts (BLDRs). Depository receipts (DRs) represent ownership in a foreign firm and are traded in the markets of other countries in local market currencies. A bank deposits shares of the foreign firm and then issues receipts representing ownership of a specific number of the foreign shares. The depository bank acts as a custodian and manages dividends, stock splits, and other events. Although the investor does not have to convert to the foreign currency, the value of the DR is affected by exchange rate changes, as well as firm fundamentals, economic events, and any other factors that affect the value of any stock. If the firm is involved with the issue, the depository receipt is a sponsored DR; otherwise, it is an unsponsored DR. A sponsored DR provides the investor voting rights and is usually subject to greater disclosure requirements. In an unsponsored DR, the depository bank retains the voting rights. Global depository receipts (GDRs) are issued outside the United States and the issuer's home country. Most GDRs are traded on the London and Luxembourg exchanges. Although not listed on U.S. exchanges, they are usually denominated in U.S. dollars Page 264 ©2015 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities and can be sold to u.s. institutional investors. GDRs are not subject to the capital flow restrictions imposed by governments and thus offer the firm and the investor greater opportunities for foreign investment. The firm usually chooses to list the GDR in a market where many investors are familiar with the firm. American depository receipts (ADRs) are denominated in U.S. dollars and trade in the United States. The security on which the ADR is based is the American depository share (ADS), which trades in the firm's domestic market. Some ADRs allow firms to raise capital in the United States or use the shares to acquire other firms. Most require U.S. Securities and Exchange Commission (SEC) registration, but some are privately placed (Rule 144A or Regulation S receipts). A The four types of ADRs, with different levels of trading availability and firm requirements, are summarized in Figure 1. Figure 1: Types of ADRs vurpomligecaVRPLICA Level I Level II Level III Rule 144A Trading location Over-thecounter (OTC) NYSE, Nasdaq, and AM EX NYSE, Nasdaq, andAMEX Private SEC registration required Yes Yes Yes No Ability to raise capital in United States No No Yes Yes Firm listing expenses Low High High Low Global registered shares (GRS) are traded in different currencies on stock exchanges around the world. A basket of listed depository receipts (BLD R) is an exchange-traded fund (ETF) that is a collection of DRs. ETF shares trade in markets just like common stocks. LOS 49.e: Compare the risk and return characteristics of different types of • • • equity securrties. CPA ® Program Curriculum, Volume 5, page 169 The returns on equity investments consist of price changes, dividend payments, and, in the case of equities denominated in a foreign currency, gains or losses from changes in exchange rates. A Japanese investor who invests in euro-denominated shares will have greater yen-based returns if the euro appreciates relative to the yen. Gains from dividends and the reinvestment of dividends have been an important part of equity investors' long-term returns. For example, $1 invested in U.S. stocks in 1900 would have been worth $834 in real terms in 2011 with dividends reinvested but only ©20 15 Kaplan, Inc. Page 265 Study Session 14 Cross- Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities $8.10 with price appreciation alone. Over the same time period, the terminal wealth for bonds and bills would have been $9.30 and $2.80, respectively.! The risk of equity securities is most commonly measured as the standard deviation of returns. Preferred stock is less risky than common stock because preferred stock pays a known, fixed dividend to investors that is a large part of the return, whereas common dividends are variable and can vary with earnings. Also, preferred stockholders receive their distributions before common shareholders and have a claim in liquidation equal to the par value of their shares that has priority over the claims of common stock owners. Because it is less risky, preferred stock has a lower average return than common stock. Cumulative preferred shares have less risk than non-cumulative preferred shares because they retain the right to receive any missed dividends before any common stock dividends can be paid. For both common and preferred shares, putable shares are less risky and callable shares are more risky compared to shares with neither option. Putable shares are less risky because if the market price drops, the investor can put the shares back to the firm at a fixed price (assuming the firm has the capital to honor the put). Because of this feature, putable shares usually pay a lower dividend yield than non-putable shares. Callable shares are the most risky because if the market price rises, the firm can call the shares, limiting the upside potential of the shares. Callable shares, therefore, usually have higher dividend yields than non-callable shares. LOS 49.f: Explain the role of equity securities in the financing of a company's assets. ywvutsrqpomligfecaVSPOECA CPA ® Program Curriculum, Volume 5, page 172 Equity capital is used for the purchase of long-term assets, equipment, research and development, and expansion into new businesses or geographic areas. Equity securities provide the firm with "currency" that can be used to buy other companies or that can be offered to employees as incentive compensation. Having publicly traded equity securities provides liquidity, which may be especially important to firms that need to meet regulatory requirements, capital adequacy ratios, and liquidity ratios. LOS 49.g: Distinguish between the market value and book value of equity • • secuntres. CPA ® Program Curriculum, Volume 5, page 172 The primary goal of firm management is to increase the book value of the firm's equity and thereby increase the market value of its equity. The book value of equity is the value of the firm's assets on the balance sheet minus its liabilities. It increases when the firm has positive net income and retained earnings that flow into the equity account. When 1. Ryan C. Fuhrmann, CFA, and Asjeet S. Lamba, CFA, Overview of Equity Securities, CFA Program Level I 2015 Curriculum, Volume 5, (CFA Institute, 2014) p. 169. Page 266 ©20 15 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities management makes decisions that increase income and retained earnings, they increase the book value of equity. The market value of equity is the total value of a firm's outstanding equity shares based on market prices and reflects the expectations of investors about the firm's future performance. Investors use their perceptions of the firm's risk and the amounts and timing of future cash flows to determine the market value of equity. The market value and book value of equity are seldom equal. Although management may be maximizing the book value of equity, this may not be reflected in the market value of equity because book value does not reflect investor expectations about future firm performance. LOS 49.h: Compare a company's cost of equity, its (accounting) return on equity, and investors' required rates of return. ywvutsrqponmlihgfedcaVTPNFDCA CFA ® Program Curriculum, Volume 5, page 172 A key ratio used to determine management efficiency is the accounting return on equity, usually referred to simply as the return on equity (ROE). ROE is calculated as net income available to common (net income minus preferred dividends) divided by the average book value of common equity over the period: ROE = t t . NIt average BVt (BVt + BV t-1) / 2 Alternatively, ROE is often calculated using only beginning-of-year (i.e., book value of equity for end of year t - 1): book value of equity The first method is more appropriate when it is the industry convention or when book value is volatile. The latter method is more appropriate when examining ROE for a number of years or when book value is stable. Higher ROE is generally viewed as a positive for a firm, but the reason for an increase should be examined. For example, if book value is decreasing more rapidly than net income, ROE will increase. This is not, however, a positive for the firm. A firm can also issue debt to repurchase equity, thereby decreasing the book value of equity. This would increase the ROE but also make the firm's shares riskier due to the increased financial leverage (debt). Professor's Note: The DuPont formula discussed in the topic review of Financial Analysis Techniques can help the analyst determine the reasonsfor changes in ROE. ROE The book value of equity reflects a firm's financial decisions and operating results since its inception, whereas the market value of equity reflects the market's consensus view of ©20 15 Kaplan, Inc. Page 267 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities a firm's future performance. The price-to-book ratio (also called the market-to-book ratio) is the market value of a firm's equity divided by the book value of its equity. The more optimistic investors are about the firm's future growth, the greater its price-to-book ratio. The price-to-book ratio is used as a measure of relative value. Often, firms with low price-to-book ratios are considered value stocks, while firms with high price-to-book ratios are considered growth stocks. wvutsronlkihgedcaYFED Example: ROE, market, and book value of equity calculations Given the figures below for O'Grady Industries, calculate the return on average equity for 20X9 and the total market value of equity, the book value per share, and the priceto-book ratio at the end of 20X9. Index Firm Data Fiscal Year-End Dec. 31 20X9 20XB Total stockholder's equity 18,503 17,143 Net income available to common 3,526 3,056 Stock price $16.80 $15.30 Shares outstanding 3,710 2,790 XB Answer: The return on average equity for 20X9 is: ROE = t VB NIt average BVt NIt (BVt + BVt-1) / 2 $3,526 = 19.780/0 ($18,503 + $17,143) /2 The total market value of the firm's equity at the end of 20X9 is: $16.80 x 3,710 = $62,328 The book value per share at the end of 20X9 is: = $18,503 = $4.99 3,710 The price-to-book ratio at the end of 20X9 is: = $16.80 = 3.37 $4.99 Investors' Required Return and the Cost of Equity A firm's cost of equity is the expected equilibrium total return (including dividends) on its shares in the market. It is usually estimated in practice using a dividend-discount model or the capital asset pricing model. At any point in time, a decrease in share price will increase the expected return on the shares and an increase in share price will Page 268 ©2015 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities decrease expected returns, other things equal. Because the intrinsic value of a firm's shares is the discounted present value of its future cash flows, an increase (decrease) in the required return used to discount future cash flows will decrease (increase) intrinsic value. Investors also estimate the expected market returns on equity shares and compare this to the minimum return they will accept for bearing the risk inherent in a particular stock. If an investor estimates the expected return on a stock to be greater than her minimum required rate of return on the shares, given their risk, then the shares are an attractive investment. Investors can have different required rates of return for a given risk, different estimates of a firm's future cash flows, and different estimates of the risk of a firm's equity shares. A firm's cost of equity can be interpreted as the minimum rate of return required by investors (in the aggregate) to compensate them for the risk of the firm's equity shares. ©20 15 Kaplan, Inc. Page 269 Study Session 14 Cross- Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities LOS 49.a Common shareholders have a residual claim on firm assets and govern the corporation through voting rights. Common shares have variable dividends which the firm is under no legal obligation to pay. Callable common shares allow the firm the right to repurchase the shares at a prespecified price. Putable common shares give the shareholder the right to sell the shares back to the firm at a pre-specified price. Preferred stock typically does not mature, does not have voting rights, and has dividends that are fixed in amount but are not a contractual obligation of the firm. Cumulative preferred shares require any dividends that were missed in the past (dividends in arrears) to be paid before common shareholders receive any dividends. Participating preferred shares receive extra dividends if firm profits exceed a prespecified level and a value greater than the par value if the firm is liquidated. Convertible preferred stock can be converted to common stock at a pre-specified conversion ratio. LOS 49.h Some companies' equity shares are divided into different classes, such as Class A and Class B shares. Different classes of common equity may have different voting rights and priority in liquidation. LOS 49.c Compared to publicly traded firms, private equity firms have lower reporting costs, greater ability to focus on long-term prospects, and potentially greater return for investors once the firm goes public. However, private equity investments are illiquid, firm financial disclosure may be limited, and corporate governance may be weaker. LOS 49.d Investors who buy foreign stock directly on a foreign stock exchange receive a return denominated in a foreign currency, must abide by the foreign stock exchange's regulations and procedures, and may be faced with less liquidity and less transparency than is available in the investor's domestic markets. Investors can often avoid these disadvantages by purchasing depository receipts for the foreign stock that trade on their domestic exchange. Global depository receipts are issued outside the United States and outside the issuer's home country. American depository receipts are denominated in U.S. dollars and are traded on U.S. exchanges. Global registered shares are common shares of a firm that trade in different currencies on stock exchanges throughout the world. Baskets of listed depository receipts are exchange-traded funds that invest in depository • receipts. Page 270 ©2015 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities LOS 49.e Equity investor returns consist of dividends, capital gains or losses from changes in share prices, and any foreign exchange gains or losses on shares traded in a foreign currency. Compounding of reinvested dividends has been an important part of an equity investor's long-term return. Preferred stock is less risky than common stock because preferred stock pays a known, fixed dividend to investors; preferred stockholders must receive dividends before common stock dividends can be paid; and preferred stockholders have a claim equal to par value if the firm is liquidated. Putable shares are the least risky and callable shares are the most risky. Cumulative preferred shares are less risky than non-cumulative preferred shares, as any dividends missed must be paid before a common stock dividend can be paid. LOS 49.f Equity securities provide funds to the firm to buy productive assets, to buy other companies, or to offer to employees as compensation. Equity securities provide liquidity that may be important when the firm must raise additional funds. LOS 49.g The book value of equity is the difference between the financial statement value of the firm's assets and liabilities. Positive retained earnings increase the book value of equity. Book values reflect the firm's past operating and financing choices. The market value of equity is the share price multiplied by the number of shares outstanding. Market value reflects investors' expectations about the timing, amount, and risk of the firm's future cash flows. LOS 49.h The accounting return on equity (ROE) is calculated as the firm's net income divided by the book value of common equity. ROE measures whether management is generating a return on common equity but is affected by the firm's accounting methods. The firm's cost of equity is the minimum rate of return that investors in the firm's equity require. Investors' required rates of return are reflected in the market prices of the firm's shares. ©20 15 Kaplan, Inc. Page 271 Study Session 14 Cross- Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities Page 272 1. Which of the following best describes the benefit of cumulative share voting? A. It provides significant minority shareholders with proportional representation on the board. B. It prevents minority shareholders from exercising excessive control. C. If cumulative dividends are not paid, preferred shareholders are given voting rights. 2. The advantage of participating preferred shares versus non-participating preferred shares is that participating preferred shares can: A. obtain voting rights. B. receive extra dividends. C. be converted into common stock. 3. Compared to public equity, which of the following is least likely to characterize private equity? A. Lower reporting costs. B. Potentially weaker corporate governance. C. Lower returns because of its less liquid market. 4. Global depository receipts are most often denominated in: A. the currency of the country where they trade and issued outside the United States. B. U.S. dollars and issued in the United States. C. U.S. dollars and issued outside the United States. 5. Which of the following types of preferred shares has the most risk for investors? A. Putable shares. B. Callable shares. C. Non-putable, non-callable shares. 6. Which of the following best describes the book value of equity? A. Management should attempt to maximize book value of equity. B. Book value of equity decreases when retained earnings increase. C. Book value of equity reflects investors' perceptions of the firm's future. 7. Which of the following causes of an increase in return on equity is most likely a positive sign for a firm's equity investors? A. A firm issues debt to repurchase equity. B. Net income is increasing at a faster rate than book value of equity. C. Net income is decreasing at a slower rate than book value of equity. ytsomlkieba ©2015 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #49 - Overview of Equity Securities 1. A Cumulative voting allows minority shareholders to gain representation on the board because they can use all of their votes for specific board members. 2. B Participating preferred shares can receive extra dividends if firm profits exceed a prespecified level and a value greater than the par value if the firm is liquidated. 3. C Private equity has less liquidity because no public market for it exists. The lower liquidity of private equity would increase required returns. 4. C Global Depository Receipts are not listed on u.s. exchanges and are most often denominated in U.S. dollars. They are not issued in the United States. 5. B Callable shares are the most risky because if the market price rises, the firm can call in the shares, limiting the investor's potential gains. Putable shares are the least risky because if the market price drops, the investor can put the shares back to the firm at a predetermined price. The risk of non-putable, non-callable shares falls in between. 6. A The primary goal of firm management is to increase the book value of equity. Ittsrnmkieca increases when retained earnings are positive. The market value of equity reflects the collective expectations of investors about the firm's future performance. 7. B Net income increasing at a faster rate than book value of equity generally would be a positive sign. If a firm issues debt to repurchase equity, this decreases the book value of equity and increases the ROE. However, now the firm becomes riskier due to the increased debt. Net income decreasing at a slower rate than book value of equity would increase ROE, but decreasing net income is not a positive sign. ©20 15 Kaplan, Inc. Page 273 The following is a review of the Equity Analysis and Valuation principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #50.YUTSRPONMLIDCA INTRODUCTION TO INDUSTRY AND COMPANY ANALYSIS Study Session 14XMEA EXAM Focus This topic provides a great deal of material on industry analysis. Understand the effects of business cycles and the stage of an industry's life cycle. Porter's five forces and two competitive strategies are very important to know. Beyond these, make sure that you know the effects on price competition and profitability of the items considered in industry analysis and of the various firm characteristics discussed. LOS SO.a: Explain uses of industry analysis and the relation of industry analysis to company analysis. vutsrponmligedcaVPCA CPA® Program Curriculum, Volume 5, page 188 Industry analysis is important for company analysis because it provides a framework for understanding the firm. Analysts will often focus on a group of specific industries so that they can better understand the business conditions the firms in those industries face. Understanding a firm's business environment can provide insight about the firm's potential growth, competition, and risks. For a credit analyst, industry conditions can provide important information about whether a firm will be able to meet its obligations during the next recession. In an active management strategy, industry analysis can identify industries that are undervalued or overvalued in order to weight them appropriately. Some investors engage in industry rotation, which is overweighting or underweighting industries based on the current phase of the business cycle. A firm's industry has been found to be as important as its home country in determining its performance. In performance attribution analysis, the sources of portfolio return are determined relative to a benchmark. The industry representation within a portfolio is often a significant component of attribution analysis. LOS SO.b: Compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system. CPA ® Program Curriculum, Volume 5, page 189 One way to group companies into an industry is by the products and services they offer. For example, the firms that produce automobiles constitute the auto industry. A sector Page 274 ©2015 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction Study Session 14 to Industry and Company Analysis is a group of similar industries. Hospitals, doctors, pharmaceutical firms, and other industries are included in the health care sector. Systems that are grouped by products and services usually use a firm's principal business activity (the largest source of sales or earnings) to classify firms. Examples of these systems are discussed in the following and include the Global Industry Classification Standard (GICS), Russell Global Sectors (RGS), and Industry Classification Benchmark. Firms can also be classified by their sensitivity to business cycles. This system has two main classifications: cyclical and non-cyclical firms. yvutsrponmlihgfedcbaSCB Statistical methods, such as cluster analysis, can also be used. This method groups firms that historically have had highly correlated returns. The groups (i.e., industries) formed will then have lower returns correlations between groups. This method has several limitations: • • • • Historical correlations may not be the same as future correlations. The groupings of firms may differ over time and across countries. The grouping of firms is sometimes non-intuitive. The method is susceptible to statistical error (i.e., firms can be grouped by a relationship that occurs by chance, or not grouped together when they should be). Industry Classification Systems Classifying firms by industry provides a method of examining trends and firm valuations. It also allows analysts to compare firms in different countries on a similar basis. The following are the industry classification systems currently available to investors. Commercial Classifications Several index providers classify firms. Some use three levels of classification, while others use four levels. The providers generally use firm fundamentals such as revenue to classify firms. Although the nomenclature differs among providers, the broadest category is generally the sector level, followed by industry and sub-industry. Commercial industry classifications include the Global Industry Classification Standard developed by Standard & Poor's and MSCI Barra, Russell Global Sectors, and the Industry Classification Benchmark developed by Dow Jones and FTSE. Sectors and firm compositions representative of those used by commercial providers are as follows. Basic materials and processing firms produce: • • • • • Building materials. Chemicals. Paper and forest products. Containers and packaging. Metals, minerals, and mining. ©20 15 Kaplan, Inc. Page 275 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Introduction to Industry and Company AnalysisyvutsrponmlihgedcbaTIHFEC Consumer discretionary firms are cyclical and sell goods and services in industries such as: • • • Automotive. Apparel. Hotels and restaurants. Consumer staples firms are less cyclical and sell goods and services in industries such as: • • • • Food. Beverage. Tobacco. Personal care products. Energy firms are involved in: • • • • • Energy exploration. Refining. Production. Energy equipment. Energy services. Financial services firms include firms involved in: • • • • • Banking. Insurance. Real estate. Asset management. Brokerage. Health care includes: • • • • • • Pharmaceuticals. Biotech. Medical devices. Health care equipment. Medical supplies. Health care services. Industrial and producer durables firms produce capital goods for commercial services industries including: • • • • • Heavy machinery and equipment. Aerospace. Defense. Transportation. Commercial services and supplies. Technology firms sell or produce: • • • • • • • Page 276 Computers. Software. Semiconductors. Communications equipment. Internet services. Electronic entertainment. Consulting and services. ©2015 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction Study Session 14 to Industry and Company Analysisywvutsrponmlihgfe Telecommunications firms include wired and wireless service providers. Utilities includes electric, gas, and water utilities. Some industry classification providers include telecommunication and utilities in the same group, while others separate them. To classify a firm accurately, an analyst should have detailed knowledge about the firm and the delineation of industry classifications. Government Classifications Several government bodies also provide industry classification of firms. They frequently do so to organize the economic data they publish. A main thrust of their systems is to make comparisons of industries consistent across time and country. The main systems are similar to each other. • • • • International Standard Industrial Classification of All Economic Activities (ISIC) was produced by the United Nations in 1948 to increase global comparability of data. Statistical Classification of Economic Activities in theEuropean Community is similar to the ISIC but is designed for Europe. Australian and New Zealand Standard Industrial Classification was jointly developed by those countries. North American Industry Classification System (NAICS) was jointly developed by the United States, Canada, and Mexico. The methodologies that government providers use in their compilation of industry groups differ from those used by commercial providers. Most governments do not identify individual firms in a group, so an analyst cannot know the groups' exact composition. Commercial providers identify the constituent firms. Government systems are updated less frequently; for example, the NAICS is updated every five years. Governments do not distinguish between small and large firms, for-profit and not-forprofit organizations, or private and public firms. Commercial providers only include forprofit and public firms and can delineate by the size of the firm. An analyst should not assume that two firms in the same narrowest industry classification can be compared with each other for fundamental analysis and valuation. Instead, the analyst should construct peer groups, as described later in this topic review. LOS 50.c: Explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descri . " an d "cyc1·IC al" • escriptors sueh"as growt,h " "d e£ensrve, la CPA ® Program Curriculum, Volume 5, page 190 A cyclical firm is one whose earnings are highly dependent on the stage of the business cycle. These firms have high earnings volatility and high operating leverage. Their products are often expensive, non-necessities whose purchase can be delayed until the economy improves. Examples of cyclical industries include basic materials and processing, consumer discretionary, energy, financial services, industrial and producer durables, and technology. ©20 15 Kaplan, Inc. Page 277 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Introduction to Industry and Company Analysis In contrast, a non-cyclical firm produces goods and services for which demand is relatively stable over the business cycle. Examples of non-cyclical industries include health care, utilities, telecommunications, and consumer staples. Sectors can also be classified by their sensitivity to the phase of the business cycle. Cyclical sector examples include energy, financials, technology, materials, and consumer discretionary. Non-cyclical sector examples include health care, utilities, and consumer staples. Non-cyclical industries can be further separated into defensive (stable) or growth industries. Defensive industries are those that are least affected by the stage of the business cycle and include utilities, consumer staples (such as food producers), and basic services (such as drug stores). Growth industries have demand so strong they are largely unaffected by the stage of the business cycle. Descriptors such as "growth," "defensive," and "cyclical" should be used with caution. Cyclical industries, which are supposed to be dependent on the business cycle, often include growth firms that are less dependent on the business cycle. Non-cyclical industries can be affected by severe recessions, as was the case in the 2008-09 downturn. Defensive industries may not always be safe investments. For example, grocery stores are classified as defensive, but they are subject to intense price competition that reduces earnings. Defensive industries may also contain some truly defensive and some growth firms. Because business cycle phases differ across countries and regions, two cyclical firms operating in different countries may be simultaneously experiencing different cyclical effects on earnings growth. LOS 50.d: Explain how a company's industry classification can be used to identify a potential "peer group" for equity valuation. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 198 A peer group is a set of similar companies an analyst will use for valuation comparisons. More specifically, a peer group will consist of companies with similar business activities, demand drivers, cost structure drivers, and availability of capital. To form a peer group, an analyst will often start by identifying companies in the same industry classification, using the commercial classification providers previously described. Usually, the analyst will use other information to verify that the firms in an industry are indeed peers. An analyst might include a company in more than one peer group. nA The following are steps an analyst would use to form a peer group: • • • • Page 278 Use commercial classification providers to determine which firms are in the same industry. Examine firms' annual reports to see if they identify key competitors. Examine competitors' annual reports to see if other competitors are named. Use industry trade publications to identify competitors. ©2015 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction • • Study Session 14 to Industry and Company Analysis Confirm that comparable firms have similar sources of sales and earnings, have similar sources of demand, and are in similar geographic markets. Adjust financial statements of non-financial companies of r any financing subsidiary data they include. LOS 50.e: Describe the elements that need to be covered in a thorough industry analysis. urpomligecaVPFCA CFA ® Program Curriculum, Volume 5, page 202 A thorough industry analysis should include the following elements: • • • • • • • • • • Evaluate the relationships between macroeconomic variables and industry trends using information from industry groups, firms in the industry, competitors, suppliers, and customers. Estimate industry variables using different approaches and scenarios. Compare with other analysts' forecasts of industry variables to confirm the validity of the analysis and potentially find industries that are misvalued as a result of consensus forecasts. Determine the relative valuation of different industries. Compare the valuations of industries across time to determine the volatility of their performance over the long run and during different phases of the business cycle. This is useful for long-term investing as well as short-term industry rotation based on the current economic environment. Analyze industry prospects based on strategic groups, which are groups of firms that are distinct from the rest of the industry due to the delivery or complexity of their products or barriers to entry. For example, full-service hotels are a distinct market segment within the hotel industry. Classify industries by life-cycle stage, whether it is embryonic, growth, shakeout, mature, or declining. Position the industry on the experience curve, which showsthe cost per unit relative to output. The curve declines because of increases in productivity and economies of scale, especially in industries with high fixed costs. Consider the forces that affect industries, which include demographic, macroeconomic, governmental, social, and technological influences. Examine the forces that determine competition within an industry. LOS 50.£: Describe the principles of strategic analysis of an industry. CFA® Program Curriculum, Volume 5, page 204 Industries differ markedly in profitability because of differences in economic fundamentals, industry structure, and degree of competition. In some industries, competition is intense and few firms earn economic profits. Economic profits, the return on invested capital minus its cost, are greater than 200/0 in some industries and negative in others. The degree of economic profits depends in part on pricing power (elasticity of demand for the firm's products). An analyst should understand that industry conditions and profits can change dramatically over time, so industry analysis should be forwardlooking. ©20 15 Kaplan, Inc. Page 279 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Introduction to Industry and Company Analysis One component of an analyst's industry analysis should be strategic analysis, which examines how an industry's competitive environment influences a firm's strategy. The analysis framework developed by Michael Porter1 delineates five forces that determine industry competition. yxwvutsrponmlihgfedcbaTRPHB 1. Rivalry among existing competitors. Rivalry increases when many firms of relatively equal size compete within an industry. Slow growth leads to competition as firms fight for market share, and high fixed costs lead to price decreases as firms try to operate at full capacity. For example, the high fixed costs in the auto industry from capital investments and labor contracts force firms to produce a large number of vehicles that they can only sell at low margins. Industries with products that are undifferentiated or have barriers (are costly) to exit tend to have high levels of • • cornpetrnon. 2. Threat of entry. Industries that have significant barriers to entry (e.g., large capital outlays for facilities) will find it easier to maintain premium pricing. It is costly to enter the steel or oil production industries. Those industries have large barriers to entry and thus less competition from newcomers. An analyst should identify factors that discourage new entrants, such as economies of scale. 3. Threat ofsubstitutes. Substitute products limit the profit potential of an industry because they limit the prices firms can charge by increasing the elasticity of demand. Commodity-like products have high levels of competition and low profit margins. The more differentiated the products are within an industry, the less price competition there will be. For example, in the pharmaceutical industry, patents protect a producer from competition in the markets for patented drugs. 4. Power of buyers. Buyers' ability to bargain for lower prices or higher quality influences industry profitability. Bargaining by governments and ever-larger health care providers have put downward pressure even on patented drugs. 5. Power of suppliers. Suppliers' ability to raise prices or limit supply influences industry profitability. Suppliers are more powerful if there are just a few of them and their products are scarce. For example, Microsoft is one of the few suppliers of operating system software and thus has pricing power. The first two forces deserve further attention because almost all firms must be concerned about the threat of new entrants and competition that would erode profits. Studying these forces also helps the analyst better understand the subject firm's competitors and prospects. The following summary describes how these two factors influence the competitive environment in an industry: • • • 1. Page 280 Higher barriers to entry reduce competition. Greater concentration (a small number of firms control a large part of the market) reduces competition, whereas market fragmentation (a large number of firms, each with a small market share) increases competition. Unused capacity in an industry, especially if prolonged, er sults in intense price competition. For example, under utilized capacity in the auto industry has resulted in • • • • very competitrve prIcIng. Michael Porter, "The Five Competitive Forces That Shape Strategy, " Harvard Business Review, Volume 86, No.1: pp. 78-93. ©20 15 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction • • • Study Session 14 to Industry and Company Analysis Stability in market share reduces competition. For example, loyalty of a firm's customers tends to stabilize market share and profits. More price sensitivity in customer buying decisions results in greater competition. Greater maturity of an industry results in slowing growth. LOS 50.g: Explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price • • competrtron. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 205 Barriers to Entry High barriers to entry benefit existing industry firms because they prevent new competitors from competing for market share and reducing the existing firms' return on capital. In industries with low barriers to entry, firms have little pricing power and competition reduces existing firms' return on capital. To assess the ease of entry, the analyst should determine how easily a new entrant to the industry could obtain the capital, intellectual property, and customer base needed to be successful. One method of determining the ease of entry is to examine the composition of the industry over time. If the same firms dominate the industry today as ten years ago, entry is probably difficult. High barriers to entry do not necessarily mean firm pricing power is high. Industries with high barriers to entry may have strong price competition among existing firms. This is more likely when the products sold are undifferentiated and commodity-like or when high barriers to exit result in overcapacity. For example, an automobile factory may have a low value in an alternative use, making firm owners less likely to exit the industry. They continue to operate even when losing money, hoping to turn things around, which can result in industry overcapacity and intense price competition. Low barriers to entry do not ensure success for new entrants. Barriers to entry may change over time, and so might the competitive environment. Industry Concentration High industry concentration does not guarantee pricing power. • • • Absolute market share may not matter as much as a firm's market share relative to its competitors. A firm may have a 500/0 market share, but if a single competitor has the other 500/0, their 500/0 share would not result in a great degree of pricing power. Return on capital is limited by intense competition between the two firms. Conversely, a firm that has a100/0 market share when no competitor has more than 20/0 may have a good degree of pricing power and high return on capital. If industry products are undifferentiated and commodity-like, then consumers will switch to the lowest-priced producer. The more importance consumers place on price, the greater the competition in an industry. Greater competition leads to lower return on capital. ©20 15 Kaplan, Inc. Page 281 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Introduction to Industry and Company Analysis • • Industries with greater product differentiation in regard to features, reliability, and service after the sale will have greater pricing power. Return on capital can be higher for firms that can better differentiate their products. If the industry is capital intensive, and therefore costlyto enter or exit, overcapacity can result in intense price competition. Tobacco, alcohol, and confections are examples of highly concentrated industries in which firms' pricing power is relatively strong. Automobiles, aircraft, and oil refining are examples of highly concentrated industries with relatively weak pricing power. Although industry concentration does not guarantee pricing power, a fragmented market does usually result in strong competition. When there are many industry members, firms cannot coordinate pricing, firms will act independently, and because each member has such a small market share, any incremental increase in market share may make a price decrease profitable. Industry Capacity Industry capacity has a clear impact on pricing power. Undercapacity, a situation in which demand exceeds supply at current prices, results in pricing power and higher return on capital. Overcapacity, with supply greater than demand at current prices, will result in downward pressure on price and lower return on capital. An analyst should be familiar with the industry's current capacity and its planned investment in additional capacity. Capacity is fixed in the short run and variable in the long run. In other words, given enough time, producers will build enough factories and raise enough capital to meet demand at a price close to minimum average cost. However, producers may overshoot the optimal industry capacity, especially in cyclical markets. For example, producers may start to order new equipment during an economic expansion to increase capacity. By the time they bring the additional production on to the market, the economy may be in a recession with decreased demand. A diligent analyst can look for signs that the planned capacity increases of all producers (who may not take into account the capacity increases of other firms) sum to more output than industry demand will support. Capacity is not necessarily physical. For example, an increase in demand for insurance can be more easily and quickly met than an increase in demand for a product requiring physical capacity, such as electricity or refined petroleum products. If capacity is physical and specialized, overcapacity can exist for an extended period if producers expand too much over the course of a business cycle. Specialized physical capacity may have a low liquidation value and be costly to reallocate to a different product. Non-physical capacity (e.g., financial capital) can be reallocated more quickly to new industries than physical capacity. Market Share Stability An analyst should examine whether firms' market shares in an industry have been stable over time. Market shares that are highly variable likely indicate a highly competitive industry in which firms have little pricing power. More stable market shares likely indicate less intense competition in the industry. Page 282 ©2015 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction Study Session 14 to Industry and Company Analysis Factors that affect market share stability include barriers to entry, introductions of new products and innovations, and the switching costs that customers face when changing from one firm's products to another. Switching costs, such as the time and expense of learning to use a competitor's product, tend to be higher for specialized or differentiated products. High switching costs contribute to market share stability and pricing power. LOS 50.h: Describe industry life cycle models, classify an industry as to life cycle stage, and describe limitations of the life-cycle concept in forecasting industry performance. ywvutsrqponmlkihgfedcbaVSRPLIHFCA CFA® Program Curriculum, Volume 5, page 213 Industry life cycle analysis should be a component of an analyst's strategic analysis. An industry's stage in the cycle has an impact on industry competition, growth, and profits. An industry's stage will change over time, so the analyst must monitor the industry on an ongoing basis. The five phases of the industry life-cycle model are illustrated in Figure 1. Figure 1: Stages of the Industry Life Cycle Matul_::re~ Demand .... Shakeout Embryonic ~~~-----------------------------------------------Time In the embryonic stage, the industry has just started. The characteristics of this stage are as follows: • • • • Slow growth: customers are unfamiliar with the product. High prices: the volume necessary for economies of scale has not been reached. Large investment required: to develop the product. High risk of failure: most embryonic firms fail. In the growth stage, industry growth is rapid. The characteristics of this stage are as follows: • • Rapid growth: new consumers discover the product. Limited competitive pressures:the threat of new firms coming into the market peaks • • during the growth phase, but rapid growth allows firms to grow without competing • on price. Falling prices: economies of scale are reached and distribution channels increase. Increasing profitability: due to economies of scale. ©20 15 Kaplan, Inc. Page 283 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Introduction to Industry and Company Analysis In the shakeout stage, industry growth and profitability are slowing due to strong competition. The characteristics of this stage are as follows: ywvutsrponmlkihgfedcbaSNIHGDC • • • • • • Growth has slowed: demand reaches saturation level with few new customers to be found. Intense competition: industry growth has slowed, so firm growth must come at the expense of competitors. Increasing industry overcapacity: firm investment exceeds increases in demand. Declining profitability: due to overcapacity. Increased cost cutting: firms restructure to survive and attempt to build brand loyalty. Increased failures: weaker firms liquidate or are acquired. In the mature stage, there is little industry growth and firms begin to consolidate. The characteristics of this stage are as follows: • • • • • Slow growth: market is saturated and demand is only for replacement. Consolidation: market evolves to an oligopoly. High barriers to entry: surviving firms have brand loyalty and low cost structures. Stable pricing: firms try to avoid price wars, although periodic price wars may occur during recessions. Superior firms gain market share:the firms with better products may grow faster than the industry average. In the decline stage, industry growth is negative. The characteristics of this stage are as follows: • • • Negative growth: due to development of substitute products, societal changes, or global competition. Declining prices: competition is intense and there are price wars due to overcapacity. Consolidation: failing firms exit or merge. An analyst should determine whether a firm is "acting its age" or stage of industry development. Growth firms should be reinvesting in operations in an attempt to increase product offerings, increase economies of scale, and build brand loyalty. They are not yet worried about cost efficiency. They should not payout cash flows to investors but save them for internal growth. On the other hand, mature firms focus on cost efficiency because demand is largely from replacement. They find few opportunities to introduce new products. These firms should typically payout cash to investors as dividends or stock repurchases because cash flows are strong but internal growth is limited. An analyst should be concerned about firms that do not act their stage, such as a mature firm that is investing in low-return projects for the sake of increasing firm size. nA Although life-cycle analysis is a useful tool, industries do not always conform to its framework. Life-cycle stages may not be as long or short as anticipated, or they might be skipped altogether. An industry's product may become obsolete quickly due to technological change, government regulation, societal change, or demographics. Lifecycle analysis is likely most useful during stable periods, not during periods of upheaval when conditions are changing rapidly. Furthermore, some firms will experience growth and profits that are dissimilar to others in their industries due to competitive advantages or disadvantages. Page 284 ©2015 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction Study Session 14 to Industry and Company Analysis LOS 50.i: Compare characteristics of representative industries from the various • economic sectors. nA yvutsrponmljihgfedcbaVTSPMLIGDCBA CPA® Program Curriculum, Volume 5, page 219 To illustrate the long list of factors to be considered in industry analysis, we use the following strategic analysis of the candy/confections industry. • • • • • • • • • • • • Major firms: Cadbury, Hershey, Mars, and Nestle. Barriers to entry and success:Very high. Low capital and technological barriers, but consumers have strong brand loyalty. Industry concentration: Very concentrated. Largest four firms dominate global market share. Influence of industry capacity on pricing: None. Pricing is determined by strength of brand, not production capacity. Industry stability: Very stable. Market share changes slowly. Life cycle:Very mature. Growth is driven by population changes. Competition: Low. Lack of unbranded candy makers in market reduces competition. Consumer decision is based on brand awareness, not price. Demographic influences: Not applicable. Government influence: Low. Industry is largely unregulated, but regulation arising from concerns about obesity is possible. Social influence: Not applicable. Technological influence: Very low. Limited impact from technology. Business cycle sensitivity: Non-cyclical and defensive. Demand for candy is very stable. LOS 50.j: Describe macroeconomic, technological, demographic, governmental, and social influences on industry growth, profitability, and risk. CPA ® Program Curriculum, Volume 5, page 222 The external influences on industry growth, profitability, and risk should be a component of an analyst's strategic analysis. These external factors include macroeconomic, technological, demographic, governmental, and social influences. Macroeconomic factors can be cyclical or structural (longer-term) trends, most notably economic output as measured by GDP or some other measure. Interest rates affect financing costs for firms and individuals, as well as financial institution profitability. Credit availability affects consumer and business expenditures and funding. Inflation affects costs, prices, interest rates, and business and consumer confidence. An example of a structural economic factor is the education level of the work force. More education can increase workers' productivity and real wages, which in turn can increase their demand for consumer goods. Technology can change an industry dramatically through the introduction of new or improved products. Computer hardware is an example of an industry that has undergone dramatic transformation. Radical improvements in circuitry were assisted by transformations in other industries, including the computer software and ©20 15 Kaplan, Inc. Page 285 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Introduction to Industry and Company Analysis telecommunications industries. Another example of an industry that has been changed by technology is photography, which has largely moved from film to digital media. ywvutsrponmlihgfecaVSPGDCA Demographic factors include age distribution and population size, as well as other changes in the composition of the population. As a large segment of the population reaches their twenties, residential construction, furniture, and related industries see increased demand. An aging of the overall population can mean significant growth for the health care industry and developers of retirement communities. For example, the aging of the postWorld War II Baby Boomers is an example of demographics that will increase demand in these industries. Governments have an important and widespread effect on businesses through various channels, including taxes and regulation. The level of tax rates certainly affects industries, but analysts should also be aware of the differential taxation applied to some goods. For example, tobacco is heavily taxed in the United States. Specific regulations apply to many industries. Entry into the health care industry, for example, is controlled by governments that license doctors and other providers. Governments can also empower self-regulatory organizations, such as stock exchanges that regulate their members. Some industries, such as the U.S. defense industry, depend heavily on government purchases of goods and services. Social influences relate to how people work, play, spend their money, and conduct their lives; these factors can have a large impact on industries. For example, when women entered the U.S. workforce, the restaurant industry benefitted because there was less cooking at home. Child care, women's clothing, and other industries were also dramatically affected. LOS 50.k: Describe the elements that should be covered in a thorough company analysis. CPA ® Program Curriculum, Volume 5, page 228 Having gained understanding of an industry's external environment, an analyst can then focus on company analysis. This involves analyzing the firm's financial condition, products and services, and competitive strategy. Competitive strategy is how a firm responds to the opportunities and threats of the external environment. The strategy may be defensive or offensive. Porter has identified two important competitive strategies that can be employed by firms within an industry: a cost leadership (low-cost) strategy or a product or service differentiation strategy. According to Porter, a firm must decide to focus on one of these two areas to compete effectively. In a low-cost strategy, the firm seeks to have the lowest costs of production in its industry, offer the lowest prices, and generate enough volume to make a superior return. The strategy can be used defensively to protect market share or offensively to gain market share. If industry competition is intense, pricing can be aggressive or even predatory. In predatory pricing, the firm hopes to drive out competitors and later increase prices. Although there are often laws prohibiting predatory pricing, it can be hard to prove if Page 286 ©2015 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction Study Session 14 to Industry and Company Analysis the firm's costs are not easily traced to a particular product. A low-cost strategy firm should have managerial incentives that are geared toward improving operating efficiency. In a differentiation strategy, the firm's products and services should be distinctive in terms of type, quality, or delivery. For success, the firm's cost of differentiation must be less than the price premium buyers place on product differentiation. The price premium should also be sustainable over time. Successful differentiators will have outstanding marketing research teams and creative personnel. ywvutsrqponmlihgfedcaTRPONFEDA A company analysis should include the following elements: • • • • • • • Firm overview, including information on operations, governance, and strengths and weaknesses. Industry characteristics. Product demand. Product costs. Pricing environment. Financial ratios, with comparisons to other firms and overtime. Projected financial statements and firm valuation. A firm's return on equity (ROE) should be part of the financial analysis. The ROE is a function of profitability, total asset turnover, and financial leverage (debt). Professor's Note: The DuPont formula discussed in the topic review of Financial Analysis Techniques can help an analyst understand what drives ROE. Analysts often use spreadsheet modeling to analyze and forecast company fundamentals. The problem with this method is that the models' complexity can make their conclusions seem precise. However, estimation is performed with error that can compound over time. As a check on a spreadsheet model's output, an analyst should consider which factors are likely to be different going forward and how this will affect the firm. Analysts should also be able to explain the assumptions of a spreadsheet model. ©20 15 Kaplan, Inc. Page 287 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Introduction to Industry and Company Analysis LOS 50.a Industry analysis is necessary for understanding a company's business environment before engaging in analysis of the company. The industry environment can provide information about the firm's potential growth, competition, risks, appropriate debt levels, and credit risk. Industry valuation can be used in an active management strategy to determine which industries to overweight or underweight in a portfolio. Industry representation is often a component in a performance attribution analysis of a portfolio's return. LOS 50.h Firms can be grouped into industries according to their products and services or business cycle sensitivity, or through statistical methods that group firms with high historical correlation in returns. Industry classification systems from commercial providers include the Global Industry Classification Standard (Standard & Poor's and MSCI Barra), Russell Global Sectors, and the Industry Classification Benchmark (Dow Jones and FTSE). Industry classification systems developed by government agencies include the International Standard Industrial Classification (ISIC), the North American Industry Classification System (NAICS), and systems designed for the European Union and Australia/New Zealand. LOS 50.c A cyclical firm has earnings that are highly dependent on the business cycle. A noncyclical firm has earnings that are less dependent on the business cycle. Industries can also be classified as cyclical or non-cyclical. Non-cyclical industries or firms can be classified as defensive (demand for the product tends not to fluctuate with the business cycle) or growth (demand is so strong that it is largely unaffected by the business cycle). Limitations of descriptors such as growth, defensive, and cyclical include the facts that cyclical industries often include growth firms; even non-cyclical industries can be affected by severe recessions; defensive industries are not always safe investments; business cycle timing differs across countries and regions; and the classification of firms is somewhat arbitrary. LOS 50.d A peer group should consist of companies with similar business activities, demand drivers, cost structure drivers, and availability of capital. To form a peer group, the analyst will often start by identifying companies in the same industry, but the analyst should use other information to verify that the firms in an industry are comparable. Page 288 ©2015 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction Study Session 14 to Industry and Company Analysis LOS 50.e A thorough industry analysis should: • Evaluate the relationships between macroeconomic variables and industry trends. • Estimate industry variables using different approaches and scenarios. • Check estimates against those from other analysts. • Compare the valuation for different industries. • Compare the valuation for industries across time to determine risk and rotation • strategIes. • Analyze industry prospects based on strategic groups. • Classify industries by their life-cycle stage. • Position the industry on the experience curve. • Consider demographic, macroeconomic, governmental, social, and technological influences. • Examine the forces that determine industry competition. LOS 50.f Strategic analysis of an industry involves analyzing the competitive forces that determine the possibility of economic profits. Porter's five forces that determine industry competition are: 1. Rivalry among existing competitors. 2. Threat of entry. 3. Threat of substitutes. 4. Power of buyers. 5. Power of suppliers. LOS 50.g High barriers to entry prevent new competitors from taking away market share, but they do not guarantee pricing power or high return on capital, especially if the products are undifferentiated or barriers to exit result in overcapacity. Barriers to entry may change • over time. While market fragmentation usually results in strong competition and low return on capital, high industry concentration may not guarantee pricing power. If industry products are undifferentiated, consumers will switch to the cheapest producer. Overcapacity may result in price wars. Capacity is fixed in the short run and variable in the long run. Undercapacity typically results in pricing power. Producers may overinvest in new capacity, especially in cyclical industries or if the capacity is physical and specialized. Non-physical capacity comes into production and can be reallocated more quickly than physical capacity. Highly variable market shares indicate a highly competitive industry. Stable market shares suggest less intense competition. High switching costs contribute to market share stability. ©20 15 Kaplan, Inc. Page 289 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Introduction to Industry and Company Analysis LOS 50.h Phases of the industry life-cycle model are the embryonic, growth, shakeout, maturity, and decline stages. • Embryonic stage: Slow growth; high prices; large investment required; high risk of failure. • Growth stage: Rapid growth; little competition; falling prices; increasing profi tabili ty. • Shakeout stage: Slowing growth; intense competition; industry overcapacity; declining profitability; cost cutting; increased failures. • Mature stage: Slow growth; consolidation; high barriers ot entry; stable pricing; superior firms gain market share. • Decline stage: Negative growth; declining prices; consolidation. A limitation of life-cycle analysis is that life-cycle stages may not be as long or short as anticipated or might be skipped altogether due to technological change, government regulation, societal change, or demographics. Firms in the same life-cycle stage will experience dissimilar growth and profits due to their competitive positions. LOS 50.i The elements of an industry strategic analysis are the major firms, barriers to entry, industry concentration, influence of industry capacity on pricing, industry stability, life cycle, competition, demographic influences, government influence, social influence, technological influence, and whether the industry is growth, defensive, or cyclical. LOS 50.j Macroeconomic influences on industries include long-term trends in factors such as GDP growth, interest rates, and inflation, as well as structural factors such as the education level of the workforce. Demographic influences include the size and age distribution of the population. Government factors include tax rates, regulations, empowerment organizations, and government purchases of goods and services. of self-regulatory Social influences relate to how people interact and conduct their lives. Technology can dramatically change an industry through the introduction improved products. of new or LOS 50.k Company analysis should include an overview of the firm, industry characteristics, and analysis of product demand, product costs, the pricing environment, the firm's financial ratios, and projected financial statements and firm valuation. The analysis should describe the company's competitive strategy. Companies can employ a cost leadership (low-cost) strategy or a product or service differentiation strategy. A cost leadership firm seeks to have the lowest costs of production in its industry, offer the lowest prices, and generate enough volume to make a superior return. A differentiating firm's products and services should be distinctive in terms of type, quality, or delivery. Page 290 ©2015 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction Study Session 14 to Industry and Company Analysis 1. Industry classification systems from commercial index providers typically classify firms by: A. statistical methods. B. products and services. C. business cycle sensitivity. 2. Firms and industries are most appropriately classified as cyclical or non-cyclical based on: A. their stock price fluctuations relative to the market. B. the sensitivity of their earnings to the business cycle. C. the volatility of their earnings relative to a peer group. 3. ytsrpomlkieba nA An analyst should most likely include two firms in the same peer group for analysis if the firms: A. are both grouped in the same industry classification. B. are similar in size, industry life-cycle stage, and cyclicality. C. derive their revenue and earnings from similar business activities. 4. The industry experience curve shows the cost per unit relative to: A. output. B. age of firms. C. industry life-cycle stage. 5. Greater pricing power is most likely to result from greater: A. unused capacity. B. market concentration. C. volatility in market share. 6. Which of the following statements best describes the relationship between pricing power and ease of entry and exit? Greater ease of entry: A. and greater ease of exit decrease pricing power. B. and greater ease of exit increase pricing power. C. decreases pricing power and greater ease of exit increases pricing power. 7. Industry overcapacity and increased cost cutting characterize which stage of the industry life cycle? A. Growth. B. Shakeout. C. Maturity. 8. Which of the following is least likely a significant external influence on industry growth? A. Social influences. B. Macroeconomic factors. C. Supplier bargaining power. ©20 15 Kaplan, Inc. Page 291 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Introduction to Industry and Company Analysis Page 292 9. Which of the following is least likely an element of an industry strategic analysis? A. Market correlations. B. Demographic influences. C. Influence of industry capacity on pricing. 10. Which of the following best describes a low-cost competitive strategy? A. Volume sold is typically modest. B. Managerial incentives promote operational efficiency. C. Success depends heavily on creative marketing and product development. ytslkieba ©2015 Kaplan, Inc. Cross-Reference to CFA Institute Assigned Reading #50 - Introduction Study Session 14 to Industry and Company Analysis 1. B The classification systems provided by S&P/MSCI Barra, Russell, and Dow Jones/FTSE classify firms according to the product or service they produce. 2. B For industry analysis, cyclical firms and industries are those with earnings that are highly dependent on the business cycle, while non-cyclical firms and industries are those with earnings that are relatively less sensitive to the business cycle. 3. C Firms should be included in a peer group if their business activities are comparable. An analyst may begin with available industry classifications when forming peer groups but should refine them based on factors including the firms' sources of demand and earnings and the geographic markets in which they operate. 4. A The experience curve shows the cost per unit relative to output. Unit cost declines at higher output volume because of increases in productivity and economies of scale, especially in industries with high fixed costs. 5. B Greater concentration (a small number of firms control a large part of the market) typically reduces competition and results in greater pricing power. Greater unused capacity in an industry, especially if chronic, results in greater price competition and less pricing power. Greater stability in market share is typically associated with greater • • prIcIng power. 6. C In industries with greater ease of entry, firms have little pricing power because new competitors can take away market share. High costs of exiting result in overcapacity and likely price wars. Greater ease of exit (i.e., low costs of exit) increases pricing power. 7. B The shakeout stage is characterized by slowed growth, intense competition, industry overcapacity, increased cost cutting, declining profitability, and increased failures. 8. C Supplier bargaining power is best characterized as a force internal to the industry. External influences on industry growth, profitability, and risk include macroeconomic, technological, demographic, governmental, and social influences. 9. A Elements of an industry strategic analysis include the major firms, barriers to entry/ success, industry concentration, influence of industry capacity on pricing, industry stability, life cycle, competition, demographic influences, government influence, social influence, technological influence, and whether the industry is growth, defensive, or cyclical. 10. B Firms that use a low-cost strategy should have managerial incentives suitable to create efficient operations. In a low-cost strategy, the firm seeks to generate high enough sales volume to make a superior return. Marketing and product development are key elements of a differentiation strategy. ©20 15 Kaplan, Inc. Page 293 The following is a review of the Equity Analysis and Valuation principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #51.YVUTSQPONLIEDCBA EQUITY VALUATION: CONCEPTS AND BASIC TOOLS Study Session 14XMEA EXAM Focus This topic review discusses the use of discounted cash flow models, price multiples, and asset-based models for stock valuation. Know when the various models are appropriate, how to apply them, and their advantages and disadvantages. This topic is foundational material for all three levels of the CFA exams. Be sure you understand these fundamental concepts. LOS 51.a: Evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 244 Recall from the topic review of Market Efficiency that intrinsic value or fundamental value is defined as the rational value investors would place on the asset if they had full knowledge of the asset's characteristics. Analysts use valuation models to estimate the intrinsic values of stocks and compare them to the stocks' market prices to determine whether individual stocks are overvalued, undervalued, or fairly valued. In doing valuation analysis for stocks, analysts are assuming that some stocks' prices deviate significantly from their intrinsic values. To the extent that market prices deviate from intrinsic values, analysts who can estimate a stock's intrinsic value better than the market can earn abnormal profits if the stock's market price moves toward its intrinsic value over time. There are several things to consider, however, in deciding whether to invest based on differences between market prices and estimated intrinsic values. 1. The larger the percentage difference between market prices and estimated values, the more likely the investor is to take a position based on the estimate of intrinsic value. Small differences between market prices and estimates of intrinsic values are to be expected. 2. The more confident the investor is about the appropriateness of the valuation model used, the more likely the investor is to take an investment position in a stock that is identified as overvalued or undervalued. Page 294 ©2015 Kaplan, Inc. Cross-Reference Study Session 14 to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools 3. The more confident the investor is about the estimated inputs used in the valuation model, the more likely the investor is to take an investment position in a stock that is identified as overvalued or undervalued. Analysts must also consider the sensitivity of a model value to each of its inputs in deciding whether to act on a difference between model values and market prices. If a decrease of one-half percent in the long-term growth rate used in the valuation model would produce an estimated value equal to the market price, an analyst would have to be quite sure of the model's growth estimate to take a position in the stock based on its estimated value. 4. Even if we assume that market prices sometimes deviate from intrinsic values, market prices must be treated as fairly reliable indications of intrinsic value. Investors must consider why a stock is mispriced in the market. Investors may be more confident about estimates of value that differ from market prices when few analysts follow a particular security. 5. Finally, to take a position in a stock identified as mispriced in the market, an investor must believe that the market price will actually move toward (and certainly not away from) its estimated intrinsic value and that it will do so to a significant extent within the investment time horizon. LOS Sl.b: Describe major categories of equity valuation models. ywvutsrqponmlihgfedcaVPFCA CFA® Program Curriculum, Volume 5, page 246 Analysts use a variety of models to estimate the value of equities. Usually, an analyst will use more than one model with several different sets of inputs to determine a range of possible stock values. In discounted cash How models (or present value models), a stock's value is estimated as the present value of cash distributed to shareholders (dividend discount models) or the present value of cash available to shareholders after the firm meets its necessary capital expenditures and working capital expenses (free cashflow to equity models). There are two basic types of multiplier models (or market multiple models) that can be used to estimate intrinsic values. In the first type, the ratio of stock price to such fundamentals as earnings, sales, book value, or cash flow per share is used to determine if a stock is fairly valued. For example, the price to earnings (PIE) ratio is frequently used by analysts. PIE The second type of multiplier model is based on the ratio of enterprise value to either earnings before interest, taxes, depreciation, and amortization (EBITDA) or revenue. Enterprise value is the market value of all a firm's outstanding securities minus cash and short-term investments. Common stock value can be estimated by subtracting the value of liabilities and preferred stock from an estimate of enterprise value. In asset-based models, the intrinsic value of common stock is estimated as total asset value minus liabilities and preferred stock. Analysts typically adjust the book values of the firm's assets and liabilities to their fair values when estimating the market value of its equity with an asset-based model. ©20 15 Kaplan, Inc. Page 295 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools LOS Sl.c: Explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-How-to-equity models. urpomligecaVPFCA CFA ® Program Curriculum, Volume 5, page 248 The dividend discount model (OOM) is based on the rationale that the intrinsic value of stock is the present value of its future dividends. The most general form of the model is as follows: where: Vo = current stock value Dt = dividend at time t ke = required rate of return on common equity toD t One-year holding period OOM. For a holding period of one year, the value of the stock today is the present value of any dividends during the year plus the present value of the expected price of the stock at the end of the year (referred to as its terminal value). The one-year holding period OOM is simply: v alue = dividend to be received (l+ke) year-end price + ..:...__----=--(l+ke) Example: One-period OOM valuation Calculate the value of a stock that paid a $1 dividend last year, if next year's dividend will be 50/0higher and the stock will sell for $13.45 at year-end. The required return is 13.20/0. Answer: The next dividend is the current dividend increased by the estimated growth rate. In this case, we have: 01 = Do x (1 + dividend growth rate) = $1.00 x (1 + 0.05) = $1.05 The present value of the expected future cash flows is: divid IVI en d : $1.05 = $0.93 1.132 . $13.45 = $ 11.88 year-en d prIce: 1.132 The current value based on the investor's expectations is: stock value Page 296 = $0.93 + $11.88 = $12.81 ©2015 Kaplan, Inc. Study Session 14 to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools Cross-Reference Multiple-year holding period DDM. With a multiple-year holding period, we simply sum the present values of the estimated dividends over the holding period and the estimated terminal value. For a two-year holding period, we have: yxvutsrqponmlkihgfedcbaYTPNIFD Professor'sNote: It is useful to think of the subscript t on dividends (Dt) and prices (Pt) as the end of period t. For example, in the preceding equation, P2 is the price at the end of Year 2. Think of it as the selling price of a share, immediately after D 2 is received. t Example: Multiple-period DDM valuation A stock recently paid a dividend of $1.00 which is expected to grow at 50/0per year. The required rate of return of 13.20/0. Calculate the value of this stock assuming that it will be priced at $14.12 two years from now. Answer: Find the PV of the future dividends: D : $1.05 = $0.93 1 1.132 D : $1.05(1.05) = $1.103 = $0.86 2 (1.132)2 1.2814 PV of dividends = 0.93 + 0.86 = $1.79 Find the PV of the future price: $14.12 = $11.02 (1.132)2 Add the present values. The current value based on the investor's expectations is $1.79 + $11.02 = $12.81. The most general form of the DDM uses an infinite holding period because a corporation has an indefinite life. In an infinite-period DDM model, the present value of all expected future dividends is calculated and there is no explicit terminal value for the stock. In practice, as we will see, a terminal value can be calculated at a time in the future after which the growth rate of dividends is expected to be constant. Free cash flow to equity (FCFE) is often used in discounted cash flow models instead of dividends because it represents the potential amount of cash that could be paid out to ©20 15 Kaplan, Inc. Page 297 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools common shareholders. That is, FCFE reflects the firm's capacity to pay dividends. FCFE is also useful for firms that do not currently pay dividends. FCFE is defined as the cash remaining after a firm meets all of its debt obligations and provides for the capital expenditures necessary to maintain existing assets and to purchase the new assets needed to support the assumed growth of the firm. In other words, it is the cash available to the firm's equity holders after a firm meets all of its other obligations. FCFE for a period is often calculated as: FCFE := net income + depreciation - increase in working capital - fixed capital investment (FCInv) - debt principal repayments + new debt issues i FCFE can also be calculated as: FCFE := cash flow from operations - FCInv + net borrowing In the second formula, net borrowing is the increase in debt during the period (i.e., amount borrowed minus amount repaid) and is assumed to be available to shareholders. Fixed capital investment must be subtracted because the firm must invest in assets to sustain itself. FCFE is projected for future periods using the firm's financial statements. Restating the general form of the DDM in terms of FCFE, we have: yutsrqponmlihgfedcaTSRPNMECA Estimating the Required Return for Equity The capital asset pricing model (CAPM) provides an estimate of the required rate of return (ki) for security i as a function of its systematic risk (!3i)' the risk-free rate (Rf), and the expected return on the market [E(Rmkt)] as: kifR ki = Rf + ~i[E(Rmkt ) - Rf ] There is some controversy over whether the CAPM is the best model to calculate the required return on equity. Also, different analysts will likely use different inputs, so there is no single number that is correct. Professor'sNote: The CAPM is discussed in detail in the Study Session on portfolio management. Recall from the topic review of Cost of Capital that for firms with publicly traded debt, analysts often estimate the required return on the firm's common equity by adding a risk premium to the firm's current bond yield. If the firm does not have publicly traded debt, an analyst can add a larger risk premium to a government bond yield. Page 298 ©2015 Kaplan, Inc. Study Session 14 to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools Cross-Reference LOS Sl.d: Calculate the intrinsic value of a non-callable, non-convertible preferred stock. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 251 Preferred stock pays a dividend that is usually fixed and usually has an indefinite maturity. When the dividend is fixed and the stream of dividends is infinite, the infinite period dividend discount model reduces to a simple ratio: Example: Preferred stock valuation A company's $100 par preferred stock pays a $5.00 annual dividend and has a required return of 8%. Calculate the value of the preferred stock. Answer: Value of the preferred stock: Op I kp IF = $5.00 I 0.08 = $62.50 In the previous example, if the dividends were paid semiannually and the preferred stock had a maturity of one year, we would use a formula similar to the one we examined earlier for common stock. Instead of the price, we would use the par value (F) paid by the firm. Instead of the required return on common, we would use the required return on preferred: value = __0-=-1_ + --0_;:2=-----2 k k 1+ p 1+ p 222 + __ F--=2'---_ 1+ k 2 p With a I-year maturity, there are two semiannual dividends of $2.50 remaining, and with a required semiannual return of 40/0 we have: value = $2.50 + $2.50 + $100 = $97.17 (1+ 0.04)1 (1+ 0.04)2 (1+ 0.04)2 ©20 15 Kaplan, Inc. Page 299 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools LOS Sl.e: Calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a twostage dividend discount model, as appropriate. zywvutsrponmlkihgfedcaWVPNMIGDCA CPA ® Program Curriculum, Volume 5, page 254 The Gordon growth model (or constant growth model) assumes the annual growth rate of dividends, gc' is constant. Hence, next period's dividend, D1, is Do(l + gc)' the second year's dividend, Dz' is Do(l + gc)2, and so on. The extended equation using this assumption gives the present value of the expected future dividends (Vo) as: gVD okgD When the growth rate of dividends is constant, this equation simplifies to the Gordon (constant) growth model: Vo = Do (1 + gc) = 01 k, - gc k, -gc Professor's Note: In much of the finance literature, you will see this model referred to as the constant growth DDM, infinite period DDM, or the Gordon growth model. Whatever you call it, memorize D lover (k minus g). Note that our valuation model for preferred stock is the same as the constant growth model with no growth (g :;:0). The assumptions of the Gordon growth model are: • • • Dividends are the appropriate measure of shareholder wealth. The constant dividend growth rate, gc' and required return on stock, ke' are never expected to change. ke must be greater than gc. If not, the math will not work. If anyone of these assumptions is not met, the model is not appropriate. Example: Gordon growth model valuation Calculate the value of a stock that paid a $2 dividend last year, if dividends are expected to grow at 50/0forever and the required return on equity is 120/0. Answer: Calculate the stock's value « D 1 / (k, - g.) :;:$2.10/ :;:$30.00 Page 300 (0.12 - 0.05) ©2015 Kaplan, Inc. Cross-Reference Study Session 14 to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Toolsyxwvutsrponmlkjihg Professor'sNote: When doing stock valuation problems on the exam, watch for words like "forever," "infinitely, " "indefinitely, " "for the foreseeable future, " and so on. This will tell you that the Gordon growth model should be used. Also watch for words like (Justpaid" or "recentlypaid. " These will refer to the last dividend, Do. Words like "will pay" or "is expected to pay" refer to Dj• This example demonstrates that the stock's value is determined by the relationship between the investor's required rate of return on equity, ke' and the projected growth rate of dividends, gc: • • • As the As the Small stock's difference between ke and gc widens, the value of the stock falls. difference narrows, the value of the stock rises. changes in the difference between ke and gc can cause large changes in the value. Because the estimated stock value is very sensitive to the denominator, an analyst should calculate several different value estimates using a range of required returns and growth rates. An analyst can also use the Gordon growth model to determine how much of the estimated stock value is due to dividend growth. To do this, assume the growth rate is zero and calculate a value. Then, subtract this value from the stock value estimated using a positive growth rate. Example: Amount of estimated stock value due to dividend growth Using the data from the previous example, calculate how much of the estimated stock value is due to dividend growth. Answer: The estimated stock value with a growth rate of zero is: Vo = D / k = $2.00 / 0.12 = $16.67 The amount of the estimated stock value due to estimated dividend growth is: $30.00 - $16.67 = $13.33 Estimating the Growth Rate in Dividends To estimate the growth rate in dividends, the analyst can use three methods: 1. Use the historical growth in dividends for the firm. 2. Use the median industry dividend growth rate. 3. Estimate the sustainable growth rate. ©20 15 Kaplan, Inc. Page 301 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools The sustainable growth rate is the rate at which equity, earnings, and dividends can continue to grow indefinitely assuming that ROE is constant, the dividend payout ratio is constant, and no new equity is sold. gROE sustainable growth « (1 - dividend payout ratio) x ROE The quantity (1 - dividend payout ratio) is also referred to as the retention rate, the proportion of net income that is not paid out as dividends and goes to retained earnings, thus increasing equity. Example: Sustainable growth rate Green, Inc., is expected to pay dividends equal to 250/0 of earnings. Green's ROE is 210/0. Calculate and interpret its sustainable growth rate. Answer: g:;:; (1- 0.25) x 210/0:;:; 15.750/0 With long-run economic growth typically in the single digits, it is unlikely that a firm could sustain 15.750/0 growth forever. The analyst should also examine the growth rate for the industry and the firm's historical growth rate to determine whether the estimate is reasonable. Some firms do not currently pay dividends but are expected to begin paying dividends at some point in the future. A firm may not currently pay a dividend because it is in financial distress and cannot afford to payout cash or because the return the firm can earn by reinvesting cash is greater than what stockholders could expect to earn by investing dividends elsewhere. For these firms, an analyst must estimate the amount and timing of the first dividend in order to use the Gordon growth model. Because these parameters are highly uncertain, the analyst should check the estimate from the Gordon growth model against estimates made using other models. Page 302 ©2015 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools Example: A firm with no current dividend A firm currently pays no dividend but is expected to pay a dividend at the end of Year 4. Year 4 earnings are expected to be $1.64, and the firm will maintain a payout ratio of 500/0. Assuming a constant growth rate of 50/0and a required rate of return of 100/0, estimate the current value of this stock. Answer: The first step is to find the value of the stock at the end of Year 3. Remember, P3 is the present value of dividends in Years 4 through infinity, calculated at the end of Year 3, one period before the first dividend is paid. rogfecbVP Calculate D4' the estimate of the dividend that will be paid at the end of Year 4: D D4 = (dividend payout ratio)(E4) = (0.5)(1.64) = $0.82 Apply the constant growth model to estimate V3: V3 = D4 /kgD(k, - g.) = $0.82 / (0.10 - 0.05) = $16.40 The second step is to calculate the current value, Vo: Vo = 16.40/ 1.13 = $12.32 Multistage Dividend Growth Models A firm may temporarily experience a growth rate that exceeds the required rate of return on the firm's equity, but no firm can maintain this relationship indefinitely. A firm with an extremely high growth rate will attract competition, and its growth rate will eventually fall. We must assume the firm will return to a more sustainable rate of growth at some point in the future in order to calculate the present value of expected future dividends. One way to value a dividend-paying firm that is experiencing temporarily high growth is to add the present values of dividends expected during the high-growth period to the present value of the constant growth value of the firm at the end of the high-growth period. This is referred to as the multistage dividend discount model. where P = n D k, n+l - gc is the terminal stock value, assuming that dividends at t = n + 1 and beyond grow at a constant rate of gc. ©20 15 Kaplan, Inc. Page 303 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools Steps in using the multistage model: • • • • • • • Determine the discount rate, ke. Project the size and duration of the high initial dividend growth rate, t'. Estimate dividends during the high-growth period. Estimate the constant growth rate at the end of the high-growth period, gc. Estimate the first dividend that will grow at the constant rate. Use the constant growth value to calculate the stock value at the end of the highgrowth period. Add the PVs of all dividends to the PV of the terminal value of the stock. tgcPD Example: Multistage growth Consider a stock with dividends that are expected to grow at 200/0per year for four years, after which they are expected to grow at 50/0per year, indefinitely. The last dividend paid was $1.00, and ke = 100/0.Calculate the value of this stock using the multistage growth model. Answer: Calculate the dividends over the high-growth period: D. = Do(l + g*) = 1.00(1.20) = $1.20 D2 = D1(1 + g") = 1.20(1.20) = 1.22 = $1.44 = D2(1 D 4 = D3(1 + g*) = 1.44(1.20) = 1.23 = $1.73 + g*) = 1.73(1.20) = 1.24 = $2.08 (rounded up) D3 Although we increase D3 by the high growth rate of 200/0to get D 4' D 4 will grow at the constant growth rate of 50/0for the foreseeable future. This property of D4 allows us to use the constant growth model formula with D4 to get P3' a time = 3 value for all the (infinite) dividends expected from time = 4 onward. PD __ 2_.0_8_ = 41.60 0.10 - 0.05 Finally, we can sum the present values of dividends 1, 2, and 3 and of P3 to get the present value of all the expected future dividends during both the high- and constant growth periods: 1.20 1.1 Page 304 + 1.44 + 1.73 + 41.60 1.12 1.13 = $34.84 1.13 ©2015 Kaplan, Inc. Cross-Reference Study Session 14 to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Toolsyxwvutsrqponmlkih Professor's Note: Many finance textbooks solve multiple stage growth problems like this one by using the first dividend that has grown at the constant long-term rate to calculate the terminal value, one period after the dividend we have used. Except for rounding, this results in the same current stock value. In fact, the constant growth model can be employed using any dividend during the assumed constant growth period. A common mistake with multistage growth problems is to calculate the future value, p 3 in this example, and then to either forget to discount it back to the present or to discount over the number of periods until the constant growth dividend is paid (four in this example) rather than using the correct number of periods for discounting the constant growth value (three periods in the example). Don't make these mistakes because question writers like to present these common errors as answer choices. LOS 51.f: Identify characteristics of companies for which the constant growth or a multi-stage dividend discount model is appropriate. CPA ® Program Curriculum, Volume 5, page 257 The Gordon growth model uses a single constant growth rate of dividends and is most appropriate for valuing stable and mature, non-cyclical, dividend-paying firms. For dividend-paying firms with dividends that are expected to grow rapidly, slowly, or erratically over some period, followed by constant dividend growth, some form of the multistage growth model should be employed. The important points are that dividends must be estimable and must grow at a constant rate after some initial period so that the constant growth model can be used to determine the terminal value of the stock. Thus, we can apply multistage dividend growth models to a firm with high current growth that will drop to a stable rate in the future or to a firm that is temporarily losing market share and growing slowly or getting smaller, as long as its growth is expected to stabilize to a constant rate at some point in the future. One variant of a multistage growth model assumes that the firm has three stages of dividend growth, not just two. These three stages can be categorized as growth, transition, and maturity. A 3-stage model would be suitable for firms with an initial high growth rate, followed by a lower growth rate during a second, transitional period, followed by the constant growth rate in the long run, such as a young firm still in the high growth phase. When a firm does not pay dividends, estimates of dividend payments some years in the future are highly speculative. In this case, and in any case where future dividends cannot be estimated with much confidence, valuation based on FCFE is appropriate as long as growth rates of earnings can be estimated. In other cases, valuation based on price multiples may be more appropriate. ©20 15 Kaplan, Inc. Page 305 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools LOS 5l.g: Explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables. urpomligecaVPCA CPA ® Program Curriculum, Volume 5, page 263 Because the dividend discount model is very sensitive to its inputs, many investors rely on other methods. In a price multiple approach, an analyst compares a stock's price multiple to a benchmark value based on an index, industry group of firms, or a peer group of firms within an industry. Common price multiples used for valuation include price-to-earnings, price-to-cash flow, price-to-sales, and price-to-book value ratios. Price multiples are widely used by analysts and readily available in numerous media outlets. Price multiples are easily calculated and can be used in time series and crosssectional comparisons. Many of these ratios have been shown to be useful for predicting stock returns, with low multiples associated with higher future returns. A critique of price multiples is that they reflect only the past because historical (trailing) data are often used in the denominator. For this reason, many practitioners use forward (leading or prospective) values in the denominator (sales, book value, earnings, etc.). The use of projected values can result in much different ratios. An analyst should be sure to use price multiple calculations consistently across firms. When we compare a price multiple, such as PIE, for a firm to those of other firms based on market prices, we are using price multiples based on comparables. By contrast, price multiples based on fundamentals tell us what a multiple should be based on some valuation model and therefore are not dependent on the current market prices of other companies to establish value. SPIFECB LOS 5l.h: Calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value. CPA ® Program Curriculum, Volume 5, page 263 Price multiples used for valuation include: • • • • Price-earnings (PIE) ratio: The PIE ratio is a firm's stock price divided by earnings per share and is widely used by analysts and cited in the press. Price-sales (PIS) ratio: The PIS ratio is a firm's stock price divided by sales per share. Price-book value (P/B) ratio: The PIB ratio is a firm's stock price divided by book value of equity per share. Price-cash flow (P/CF) ratio: The PICF ratio is a firm's stock price divided by cash flow per share, where cash flow may be defined as operating cash flow or free cash flow. Other multiples can be used that are industry specific. For example, in the cable television industry, stock market capitalization is compared to the number of subscribers. Page 306 ©2015 Kaplan, Inc. Study Session 14 to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools Cross-Reference Multiples Based on Fundamentals To understand fundamental price multiples, consider the Gordon growth valuation model: p - D1 p.0- k-g If we divide both sides of the equation by next year's projected earnings, E1, we get: IE utsrqonlihgedaPIED D1 I E1 , which is the leading PIE for this stock if it is valued in the market k-g according to the constant growth DDM. This PIE based on fundamentals is also referred to as a justified PIE. It is "justified" because, assuming we have the correct inputs for D1, E1, ke' and g, the equation above will provide a PIE ratio that is based on the present value of the future cash flows. We refer to this as a leading PIE ratio because it is based on expected earnings next period, not on actual earnings for the previous period, which would produce a lagging or trailing PIE ratio. One advantage of this approach is that it makes clear how the firm's PIE ratio should be related to its fundamentals. It illustrates that the PIE ratio is a function of: • • • D1 I E1 = expected dividend payout ratio. k= required rate of return on the stock. g= expected constant growth rate of dividends. Example: PIE based on fundamentals A firm has an expected dividend payout ratio of 600/0, a required rate of return of 110/0, and an expected dividend growth rate of 50/0. Calculate the firm's fundamental (justified) leading PIE ratio. Answer: expected PIE ratio: 0.6 I (0.11 - 0.05) = 10 The justified PIE ratio serves as a benchmark for the price at which the stock should trade. In the previous example, if the firm's actual PIE ratio (based on the market price and expected earnings) was 16, the stock would be considered overvalued. If the firm's market PIE ratio was 7, the stock would be considered undervalued. PIE ratios based on fundamentals are very sensitive to the inputs (especially the denominator, k - g), so the analyst should use several different sets of inputs to indicate a range for the justified PIE. Because we started with the equation for the constant growth DDM, the PIE ratio calculated in this way is the PIE ratio consistent with the constant growth DDM. We can see from the formula that, other things equal, the PIE ratio we have defined here will ©20 15 Kaplan, Inc. Page 307 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools increase with (1) a higher dividend payout rate, (2) a higher growth rate, or (3) a lower required rate of return. So, if the subject firm has a higher dividend payout ratio, higher growth rate, and lower required return than its peers, a higher PIE ratio may be justified. yxwvutsrqonmlihgfedcbaWPNIHEA In practice, other things are not equal. An increase in the dividend payout ratio, for example, will reduce the firm's sustainable growth rate. While higher dividends will increase firm value, a lower growth rate will decrease firm value. This relationship is referred to as the dividend displacement of earnings. The net effect on firm value of increasing the dividend payout ratio is ambiguous. As intuition would suggest, firms cannot continually increase their PIEs or market values by increasing the dividend payout ratio. Otherwise, all firms would have 1000/0 payout ratios. Professor's Note: Watch for the wording "other things equal" or "other variables unchanged" in any exam questions about the effect of changing one variable. Example: Fundamental PIE ratio comparison Holt Industries makes decorative items. The figures below are for Holt and its industry. Holt Industries Industry Average Dividend payout ratio 25% 160/0 Sales growth 7.50/0 3.9% Total debt to equity 113% 680/0 Which of these factors suggest a higher fundamental PIE ratio for Holt? Answer: • • • The higher dividend payout ratio supports Holt having a higher PIE ratio than the industry. Higher growth in sales suggests that Holt will be able to increase dividends at a faster rate, which supports Holt having a higher PIE ratio than the industry. The higher level of debt, however, indicates that Holt has higher risk and a higher required return on equity, which supports Holt having a lower PIE ratio than the industry. Multiples Based on Comparables Valuation based on price multiple comparables (or cornps) involves using a price multiple to evaluate whether an asset is valued properly relative to a benchmark. Common benchmarks include the stock's historical average (a time series comparison) or similar stocks and industry averages (a cross-sectional comparison). Comparing firms within an industry is useful for analysts who are familiar with a particular industry. Price multiples are readily calculated and provided by many media outlets. Page 308 ©2015 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools The economic principle guiding this method is the law of one price, which asserts that two identical assets should sell at the same price, or in this case, two comparable assets should have approximately the same multiple. The analyst should be sure that any comparables used really are comparable. Price multiples may not be comparable across firms if the firms are different sizes, are in different industries, or will grow at different rates. Furthermore, using PIE ratios for cyclical firms is complicated due to their sensitivity to economic conditions. In this case, the PIS ratio may be favored over the PIE ratio because the sales are less volatile than earnings due to both operating and financial leverage. yutsronligedcaYSRPLIFECB The disadvantages of using price multiples based on comparables are (1) a stock may appear overvalued by the comparable method but undervalued by the fundamental method, or vice versa; (2) different accounting methods can result in price multiples that are not comparable across firms, especially internationally; and (3) price multiples for cyclical firms may be greatly affected by economic conditions at a given point in time. Example: Valuation using comparables The following figures are for Renee's Bakery. All figures except the stock price are in millions. 20)(3 20)(2 20XI Total stockholder's equity $55.60 $54.10 $52.60 Net revenues $77.30 $73.60 $70.80 $3.20 $1.10 $0.40 Net cash flow from operations $17.90 $15.20 $12.20 Stock price $11.40 $14.40 $12.05 4.476 3.994 3.823 Fiscal Year-End XI Net income Shares outstanding Calculate Renee's lagging PIE, PICF, PIS, and PIB ratios. Judge whether the firm is undervalued or overvalued using the following relevant industry averages for 20X3 and the firm's historical trend. Lagging Industry Ratios 20)(3 Price- to-earnings 8.6 Price-to-cash flow 4.6 Price- to-sales 1.4 Price-to-book value 3.6 Answer: To calculate the lagging price multiples, first divide the relevant financial statement items by the number of shares to get per-share amounts. Then, divide the stock price by this figure. ©20 15 Kaplan, Inc. Page 309 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools For example, for the PIS ratio for 20X3, divide net revenue (net sales) by the number of shares: SPIFECB sales = $77.30 = 17.270 number of shares 4.476 Then, divide the stock price by sales per share: p = $11.40 = 0.7 S 17.3 Using the net income for earnings, the net cash flow from operations for the cash flow, and stockholder's equity for book value, the ratios for Renee's Bakery are: XI 20X3 20)(2 20XISPIFECB PIE PICF PIS 15.9 52.3 115.2 2.9 3.8 3.8 0.7 0.8 0.7 PIB 0.9 1.1 0.9 Comparing Renee's Bakery's ratios to the industry averages for 20X3, the price multiples are lower in all cases except for the PIE multiple. This cross-sectional evidence suggests that Renee's Bakery is undervalued. The PIE ratio merits further investigation. Renee's Bakery may have a higher PIE because its earnings are depressed by high depreciation, interest expense, or taxes. Calculating the price-EBITDA ratio would provide an alternative measure that is unaffected by these expenses. On a time series basis, the ratios are trending downward. This indicates that Renee's Bakery may be currently undervalued relative to its past valuations. We could also calculate average price multiples for the ratios over 20XI-20X3 as a benchmark for the current values: Company average PIE 20XI-20X3 61.1 Company average PICF 20XI-20X3 3.5 Company average PIS 20XI-20X3 0.7 Company average PIB 20XI-20X3 1.0 The current PIE, PICF, and PIB ratios are lower than their 3-year averages. This indicates that Renee's Bakery may be currently undervalued. It also may be the case, however, that PIE ratios for the market as a whole have been decreasing over the period due to systematic factors. Page 310 ©2015 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools LOS 51.i: Describe enterprise value multiples and their use in estimating equity value. urpomligecaVPFCA CFA® Program Curriculum, Volume 5, page 271 Enterprise value (EV) measures total company value. EV can be viewed as what it would cost to acquire the firm: EV = market value of common and preferred stock + market value of debt - cash and short-term investments Cash and short-term investments are subtracted because an acquirer's cost for a firm would be decreased by the amount of the target's liquid assets. Although an acquirer assumes the firm's debt, it also receives the firm's cash and short-term investments. Enterprise value is appropriate when an analyst wants to compare the values of firms that have significant differences in capital structure. EBITDA (earnings before interest, taxes, depreciation, and amortization are subtracted) is probably the most frequently used denominator for EV multiples; operating income can also be used. Because the numerator represents total company value, it should be compared to earnings of both debt and equity owners. An advantage of using EBITDA instead of net income is that EBITDA is usually positive even when earnings are not. When net income is negative, value multiples based on earnings are meaningless. A disadvantage of using EBITDA is that it often includes non-cash revenues and expenses. A potential problem with using enterprise value is that the market value of a firm's debt is often not available. In this case, the analyst can use the market values of similar bonds or can use their book values. Book value, however, may not be a good estimate of market value if firm and market conditions have changed significantly since the bonds were issued. Example: Calculating EV/EBITDA multiples Daniel, Inc., is a manufacturer of small refrigerators and other appliances. The following figures are from Daniel's most recent financial statements except for the market value of long-term debt, which has been estimated from financial market data. Stock price $30.00 Shares outstanding 300,000 $800,000 Market value of long-term debt Book value of long-term debt $1,100,000 Book value of total debt $2,600,000 Cash and marketable securities $300,000 $1,200,000 EBITDA Calculate the EV/EBITDA multiple. ©20 15 Kaplan, Inc. Page 311 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools Answer: First, we must estimate the market value of the firm's short-term debt and liabilities. To do so, subtract the book value of long-term debt from the book value of total debt: $2,600,000 - $1,100,000 = $1,500,000. This is the book value of the firm's short-term debt. We can assume the market value of these short-term items is close to their book value. (As we will see in the Study Session on fixed income valuation, the market values of debt instruments approach their face values as they get close to maturity.) Add the market value of long-term debt to get the market value of total debt: $800,000 + $1,500,000 = $2,300,000. The market value of equity is the stock price multiplied by the number of shares: $30 x 300,000 = $9,000,000. The enterprise value of the firm is the sum of debt and equity minus cash: $2,300,000 + $9,000,000 - $300,000 = $11,000,000. EV/EBITDA = $11,000,000 I $1,200,000 = 9.2. I If the competitor or industry average EV/EBITDA is above 9.2, Daniel is relatively undervalued. If the competitor or industry average EV/EBITDA is below 9.2, Daniel is relatively overvalued. LOS 51.j: Describe asset-based valuation models and their use in estimating equity value. urpomligecaVPFCA CFA® Program Curriculum, Volume 5, page 274 Our third category of valuation model is asset-based models, which are based on the idea that equity value is the market or fair value of assets minus the market or fair value of liabilities. Because market values of firm assets are usually difficult to obtain, the analyst typically starts with the balance sheet to determine the values of assets and liabilities. In most cases, market values are not equal to book values. Possible approaches to valuing assets are to value them at their depreciated values, inflation-adjusted depreciated values, or estimated replacement values. Applying asset-based models is especially problematic for a firm that has a large amount of intangible assets, on or off the balance sheet. The effect of the loss of the current owners' talents and customer relationships on forward earnings may be quite difficult to measure. Analysts often consider asset-based model values as floor or minimum values when significant intangibles, such as business reputation, are involved. An analyst should consider supplementing an asset-based valuation with a more forward-looking valuation, such as one from a discounted cash flow model. Asset-based model valuations are most reliable when the firm has primarily tangible short-term assets, assets with ready market values (e.g., financial or natural resource firms), or when the firm will cease to operate and is being liquidated. Asset-based models Page 312 ©2015 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools are often used to value private companies but may be increasingly useful for public firms as they move toward fair value reporting on the balance sheet. Example: Using an asset-based model for a public firm Williams Optical is a publicly traded firm. An analyst estimates that the market value of net fixed assets is 1200/0of book value. Liability and short-term asset market values are assumed to equal their book values. The firm has 2,000 shares outstanding. nA Using the selected financial results in the table, calculate the value of the firm's net assets on a per-share basis. Cash $10,000 Accounts receivable $20,000 Inventories $50,000 Net fixed assets $120,000 Total assets $200,000 Accounts payable $5,000 Notes payable $30,000 Term loans $45,000 Common stockholder equity $120,000 Total assets $200,000 Answer: Estimate the market value of assets, adjusting the fixed assets for the analyst's estimates of their market values: $10,000 + $20,000 + $50,000 + $120,000(1.20) = $224,000 Determine the market value of liabilities: $5,000 + 30,000 + $45,000 = $80,000 Calculate the adjusted equity value: $224,000 - $80,000 = $144,000 Calculate the adjusted equity value per share: I $144,000 I 2,000 = $72 ©20 15 Kaplan, Inc. Page 313 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools LOS 51.k: Explain advantages and disadvantages of each category of valuation model. urpomligecaVPIFECA CFA ® Program Curriculum, Volume 5, page 246 Advantages of discounted cash flow models: • • They are based on the fundamental concept of discounted present value and are well grounded in finance theory. They are widely accepted in the analyst community. Disadvantages of discounted cash flow models: • • Their inputs must be estimated. Value estimates are very sensitive to input values. Advantages of comparable valuation using price multiples: • • • • • Evidence that some price multiples are useful for predicting stock returns. Price multiples are widely used by analysts. Price multiples are readily available. They can be used in time series and cross-sectional comparisons. EV/EBITDA multiples are useful when comparing firm values independent of capital structure or when earnings are negative and the PIE ratio cannot be used. Disadvantages of comparable valuation using price multiples: • • • • • • Lagging price multiples reflect the past. Price multiples may not be comparable across firms if the firms have different size, products, and growth. Price multiples for cyclical firms may be greatly affected by economic conditions at a • • • • gIven pOInt In time. A stock may appear overvalued by the comparable method but undervalued by a fundamental method or vice versa. Different accounting methods can result in price multiples that are not comparable across firms, especially internationally. A negative denominator in a price multiple results in a meaningless ratio. The PIE ratio is especially susceptible to this problem. Advantages of price multiple valuations based on fundamentals: • • They are based on theoretically sound valuation models. They correspond to widely accepted value metrics. Disadvantage of price multiple valuations based on fundamentals: • Price multiples based on fundamentals the k - g denominator). will be very sensitive to the inputs (especially Advantages of asset-based models: • • • Page 314 They can provide floor values. They are most reliable when the firm has primarily tangible short-term assets, assets with ready market values, or when the firm is being liquidated. They are increasingly useful for valuing public firms that report fair values. ©20 15 Kaplan, Inc. Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools Disadvantages of asset-based models: • • • • Market values are often difficult to obtain. Market values are usually different than book values. They are inaccurate when a firm has a high proportion of intangible assets or future cash flows not reflected in asset values. Assets can be difficult to value during periods of hyperinflation. ©20 15 Kaplan, Inc. Page 315 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools LOS 51.a An asset is fairly valued if the market price is equal to its estimated intrinsic value, undervalued if the market price is less than its estimated value, and overvalued if the market price is greater than the estimated value. For security valuation to be profitable, the security must be mispriced now and price must converge to intrinsic value over the investment horizon. Securities that are followed by many investors are more likely to be fairly valued than securities that are neglected by analysts. LOS 51.b Discounted cash flow models estimate the present value of cash distributed to shareholders (dividend discount models) or the present value of cash available to shareholders after meeting capital expenditures and working capital expenses (free cash flow to equity models). Multiplier models compare the stock price to earnings, sales, book value, or cash flow. Alternatively, enterprise value is compared to sales or EBITDA. Asset-based models define a stock's value as the firm's total asset value minus liabilities and preferred stock, on a per-share basis. LOS 51.c The dividend discount model is based on the rationale that a corporation has an indefinite life, and a stock's value is the present value of its future cash dividends. The most general form of the model is: Free cash flow to equity (FCFE) can be used instead of dividends. FCFE is the cash remaining after a firm meets all of its debt obligations and provides for necessary capital expenditures. FCFE reflects the firm's capacity for dividends and is useful for firms that currently do not pay a dividend. By using FCFE, an analyst does not need to project the amount and timing of future dividends. LOS 51.d Preferred stock typically pays a fixed dividend and does not mature. It is valued as: preferred stock value Page 316 ©2015 Kaplan, Inc. Cross-Reference Study Session 14 to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools LOS 5l.e The Gordon growth model assumes the growth rate in dividends is constant: "vo -_ Dl k, -gc vongID The sustainable growth rate is the rate at which earnings and dividends can continue to grow indefinitely: g = b x ROE where: b = earnings retention rate = 1 - dividend payout rate ROE = return on equity A firm with high growth over some number of periods followed by a constant growth rate of dividends forever can be valued using a multistage model: vaIue Dl D2 n, =( )+ 2 + ...+ + 1 + k, (1 + k, ) (1 + k, )n (1 + k, )n where: Dn+1 k, -gc gc n = = constant growth rate of dividends number of periods of supernormal growth LOS 5l.f The constant growth model is most appropriate for firms that pay dividends that grow at a constant rate, such as stable and mature firms or noncyclical firms such as utilities and food producers in mature markets. A 2-stage DDM would be most appropriate for a firm with high current growth that will drop to a stable rate in the future, an older firm that is experiencing a temporary high growth phase, or an older firm with a market share that is decreasing but expected to stabilize. A 3-stage model would be appropriate for a young firm still in a high growth phase. LOS 5l.g The PIE ratio based on fundamentals is calculated as: PIE If the subject firm has a higher dividend payout ratio, higher growth rate, and lower required return than its peers, it may be justified in having a higher PIE ratio. Price multiples are widely used by analysts, are easily calculated and readily available, and can be used in time series and cross-sectional comparisons. ©20 15 Kaplan, Inc. Page 317 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools LOS 51.h The price-earnings (PIE) ratio is a firm's stock price divided by earnings per share. SPIFECB The price-sales (PIS) ratio is a firm's stock price divided by sales per share. The price-book value (P/B) ratio is a firm's stock price divided by book value per share. The price-cash flow (P/CF) ratio is a firm's stock price divided by cash flow per share. Cash flow may be defined as operating cash flow or free cash flow. LOS 51.i Enterprise value (EV) measures total company value: EV == market value of common and preferred stock + market value of debt - cash and short-term investments EBITDA is frequently used as the denominator in EV multiples because EV represents total company value, and EBITDA represents earnings available to all investors. LOS 51.j Asset-based models value equity as the market or fair value of assets minus liabilities. These models are most appropriate when a firm's assets are largely tangible and have fair values that can be established easily. LOS 51.k Advantages of discounted cash flow models: • Easy to calculate. • Widely accepted in the analyst community. • FCFE model is useful for firms that currently do not pay a dividend. • Gordon growth model is useful for stable, mature, noncyclical firms. • Multistage models can be used for firms with nonconstant growth. Disadvantages of discounted cash flow models: • Inputs must be forecast. • Estimates are very sensitive to inputs. • For the Gordon growth model specifically: • Very sensitive to the k - g denominator. • Required return on equity must be greater than the growth rate. • Required return on equity and growth rate must remain constant. • Firm must pay dividends. Page 318 ©2015 Kaplan, Inc. Cross-Reference Study Session 14 to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools Advantages of price multiples: • Often useful for predicting stock returns. • Widely used by analysts. • Easily calculated and readily available. • Can be used in time series and cross-sectional comparisons. • EV/EBITDA multiples are useful when comparing firm valuesindependent of capital structure or when earnings are negative and the PIE ratio cannot be used. SPIE Disadvantages of price multiples: • PIE ratio based on fundamentals will be very sensitive to the inputs. • May not be comparable across firms, especially internationally. • Multiples for cyclical firms may be greatly affected by economic conditions. PIE ratio may be especially inappropriate. (The PIS multiple may be more appropriate for cyclical firms.) • A stock may appear overvalued by the comparable method but undervalued by the fundamental method or vice versa. • Negative denominator results in a meaningless ratio; the PIE ratio is especially susceptible to this problem. • A potential problem with EV/EBITDA multiples is that the market value of a firm's debt is often not available. Advantages of asset-based models: • Can provide floor values. • Most reliable when the firm has mostly tangible short-term assets, assets with a ready market value, or when the firm is being liquidated. • May be increasingly useful for valuing public firms if theyreport fair values. Disadvantages of asset-based models: • Market values of assets can be difficult to obtain and are usually different than book values. • Inaccurate when a firm has a large amount of intangible assets or future cash flows not reflected in asset value. • Asset values can be difficult to value during periods of hyperinflation. ©20 15 Kaplan, Inc. Page 319 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools 1. nkgcA An analyst estimates a value of $45 for a stock with a market price of $50. The analyst is most likely to conclude that a stock is overvalued if: A. few analysts follow the stock and the analyst has less confidence in his model • Inputs. B. few analysts follow the stock and the analyst is confident in his model • Inputs. C. many analysts follow the stock and the analyst is confident in his model • Inputs. ytsomlkie Page 320 2. An analyst estimates that a stock will pay a $2 dividend next year and that it will sell for $40 at year-end. If the required rate of return is 150/0,what is the value of the stock? A. $33.54. B. $36.52. c. $43.95. 3. What would an investor be willing to pay for a share of preferred stock that pays an annual $7 dividend if the required return is 7.750/0? A. $77.50. B. $87.50. C. $90.32. 4. The constant growth model requires which of the following? A. g < k. B. g> k. c. g -:;e k. 5. What is the intrinsic value of a company's stock if dividends are expected to grow at 50/0,the most recent dividend was $1, and investors' required rate of return for this stock is 100/0? A. $20.00. B. $21.00. C. $22.05. 6. Next year's dividend is expected to be $2, g = 70/0,and k = 120/0.What is the stock's intrinsic value? A. $28.57. B. $40.00. C. $42.80. 7. The XX Company paid a $1 dividend in the most recent period. The company is expecting dividends to grow at a 60/0rate into the future. What is the value of this stock if an investor requires a 15% rate of return on stocks of this risk class? A. $10.60. B. $11.11. C. $11.78. ©2015 Kaplan, Inc. Cross-Reference 8. Study Session 14 to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools Assume that a stock is expected to pay dividends at the end of Year 1 and Year 2 of $1.25 and $1.56, respectively. Dividends are expected to grow at a 50/0rate thereafter. Assuming that ke is 110/0,the value of the stock is closest to: A. $22.30. B. $23.42. c. $24.55. ytsrpomlkieca c 9. An analyst feels that Brown Company's earnings and dividends will grow at 25% for two years, after which growth will fall to a constant rate of 60/0.If the projected discount rate is 100/0,and Brown's most recently paid dividend was $1, the value of Brown's stock using the multistage dividend discount model is closest to: A. $31.25. B. $33.54. c. $36.65. 10. A firm has an expected dividend payout ratio of 60% and an expected future growth rate of 70/0.What should the firm's fundamental price-to-earnings (PIE) ratio be if the required rate of return on stocks of this type is 150/0? A. 5.0x. B. 7.5x. C. 10.0x. PIE 11. Which of the following firms would most likely be appropriately valued using the constant growth DDM? A. An auto manufacturer. B. A producer of bread and snack foods. C. A biotechnology firm in existence for two years. 12. Which of the following is least likely a rationale for using price multiples? A. Price multiples are easily calculated. B. The fundamental PIE ratio is insensitive to its inputs. C. The use of forward values in the divisor provides an incorporation of the future. 13. Which of the following firms would most appropriately be valued using an assetbased model? A. An energy exploration firm in financial distress that owns drilling rights for offshore areas. B. A paper firm located in a country that is experiencing high inflation. C. A software firm that invests heavily in research and development and frequently introduces new products. ©20 15 Kaplan, Inc. Page 321 Study Session 14 Cross-Reference to CFA Institute Assigned Reading #51 - Equity Valuation: Concepts and Basic Tools 1. B If the analyst is more confident of his input values, he is more likely to conclude that the security is overvalued. The market price is more likely to be correct for a security followed by many analysts and less likely correct when few analysts follow the security. 2. B ($40 + $2) / 1.15 = $36.52 3. C The share value is 7.0 / 0.0775 = $90.32. 4. A For the constant growth model, the constant growth rate (g) must be less than the required rate of return (k). 5. B Using the constant growth model, $1(1.05) / (0.10 - 0.05) = $21.00. 6. B Using the constant growth model, $2 / (0.12 - 0.07) = $40.00. 7. C Using the constant growth model, $1 (1.06) / (0.15 - 0.06) =B$11.7B. B.nCA C 9. Page 322 C ($1.25/1.11)+[1.56/(0.11-0.05)]/1.11=$24.55. $1(1.25) / 1.1 + [$1(1.25)2/ (0.10 - 0.06)] / 1.1 = $36.65. 10. B Using the earnings multiplier model, 0.6/ (0.15 - 0.07) = 7.5x. 11. B The constant growth DDM assumes that the dividend growth rate is constant. The most likely choice here is the bread and snack producer. Auto manufacturers are more likely to be cyclical than to experience constant growth. A biotechnology firm in existence for two years is unlikely to pay a dividend, and if it does, dividend growth is unlikely to be constant. 12. B The fundamental PIE ratio is sensitive to its inputs. It uses the DDM as its framework, and the denominator k - g in both has a large impact on the calculated PIE or stock value. 13. A The energy exploration firm would be most appropriately valued using an asset-based model. Its near-term cash flows are likely negative, so a forward-looking model is of limited use. Furthermore, it has valuable assets in the form of drilling rights that likely have a readily determined market value. The paper firm would likely not be appropriately valued using an asset-based model because high inflation makes the values of a firm's assets more difficult to estimate. An asset-based model would not be appropriate to value the software firm because the firm's value largely consists of internally developed intangible assets. ©2015 Kaplan, Inc. 12 questions: 18 minutes 1. ncA An investor purchased 550 shares of Akley common stock for $38,500 in a margin account and posted initial margin of 500/0.The maintenance margin requirement is 35%. The price of Akley, below which the investor would get a margin call, is closest to: A. $45.00. B. $54.00. c. $59.50. ytsrpomlkiecba 2. Adams owns 100 shares of Brikley stock, which is trading at $86 per share, and Brown is short 200 shares of Brikley. Adams wants to buy 100 more shares if the price rises to $90, and Brown wants to cover his short position and take profits if the price falls to $75. The orders Adams and Brown should enter to accomplish their stated objectives are: Adams Brown A. Limit buy @ 90 Limit buy @ 75 B. Limit buy @ 90 Stop buy @ 75 c. Stop buy @ 90 Limit buy @ 75 3. Which of the factors that determine the intensity of industry competition is most likely to be affected by the presence of significant economies of scale? A. Threat of entry. B. Threat of substitutes. c. Power of suppliers. 4. Price-to-book value ratios are most appropriate for measuring the relative value of a: A. bank. B. manufacturing company. c. mature technology company. 5. An index of three non-dividend paying stocks is weighted by their book values of equity. After one year, the stock with the largest weight is down 150/0,the next-largest is down 100/0,and the smallest is down 5%. The total return of this index for the year is: A. less than the price return of the index. B. equal to the price return of the index. c. greater than the price return of the index. 6. Financial intermediaries that buy securities from and sell securities to investors are best described as: A. dealers. B. brokers. c. investment bankers. ©20 15 Kaplan, Inc. a Page 323 Self-Test: Equity Investments 7. Among the types of assets that trade in organized markets, asset-backed securities are best characterized as: A. real assets. ytsomlkiecba B B. • • • equity secunties. C. pooled investment vehicles. 8. Which of the following market indexes is likely to be reconstituted most frequently? An index that is designed to measure: A. real estate returns. B. growth stock prices. C. commercial paper yields. nA 9. Rogers Partners values stocks using a dividend discount model and the CAPM. Holding all other factors constant, which of the following is least likely to increase the estimated value of a stock? A. An increase in the next period's expected dividend. B. A decrease in the stock's systematic risk. C. A decrease in the expected growth rate of dividends. 10. Brandy Clark, CFA, has forecast that Aceler, Inc., will pay its first dividend two years from now in the amount of $1.25. For the following year she forecasts a dividend of $2.00 and expects dividends to increase at an average rate of 70/0 for the foreseeable future after that. If the risk-free rate is 4.50/0, the market risk premium is 7.50/0, and Aceler's beta is 0.9, Clark would estimate the current value of Aceler shares as being closest to: A. $37. B. $39. C. $47. Page 324 11. An arbitrageur buys a security on a European exchange, where it is quoted in euros, and simultaneously sells the same security on a U.S. exchange, where it is quoted in dollars. The security is most likely a: A. global registered share. B. global depository receipt. C. sponsored depository receipt. 12. Under what financial market conditions can active portfolio management outperform a passive index tracking strategy consistently over time? Active management: A. cannot outperform a passive strategy if markets are weak-form efficient. B. can outperform a passive strategy if markets are weak-form efficient but not semistrong-form efficient. C. can outperform a passive strategy if markets are semistrong-form efficient but not strong-form efficient. ©2015 Kaplan, Inc. Self-Test: Equity Investments 1. B The price below which the investor would receive a margin call is: 38,500 1-0.5 550 1- 0.35 = $53.85 2. C Adams should enter a stop buy at 90, which will be executed only if the stock price rises to 90. Brown should enter a buy order with a limit at 75 because he wants to buy stock to close out his short position if he can purchase it at 75 (or less). 3. A Economies of scale represent a barrier to entry into an industry. Existing competitors are likely to be operating on a large scale that new entrants would find difficult and expensive to develop, reducing the threat of entry. 4. A Price-to-book value is an appropriate measure of relative value for firms that hold primarily liquid assets, such as banks. Manufacturing companies typically have a large proportion of fixed assets for which the book value (historical cost less depreciation) may be less relevant as a measure of their economic value. A mature technology company likely has valuable intangible assets, such as patents and human capital, that may not be reflected fully (or at all) on the balance sheet. 5. B Because the stocks in the index do not pay dividends, there is no difference between the price return and the total return, regardless of the weighting system used or the direction of price movement. 6. A Dealers maintain inventories of securities and buy them from and sell them to investors. Brokers do not trade directly with clients but find buyers for and sellers of securities to execute customer orders. Investment banks are primarily involved in assisting with the issuance of new securities. 7. C Asset-backed securities represent claims to a portion of a financial asset pool. 8. C An index of commercial paper yields needs to be reconstituted frequently because its constituent securities need to be replaced when they mature and commercial paper matures in 270 days or less. Indexes of growth stocks and real estate are likely to be reviewed periodically to confirm that their constituent assets still meet the qualifications to be included in the index. 9. C Other things equal, a decrease in the expected growth rate of dividendsg (g) will decrease the value of a stock estimated with the dividend discount model. Using the CAPM, a decrease in the stock's systematic risk would decrease the required return on equity and increase the present value of the future dividends. 10. B The required rate of return on Aceler shares is 4.5 + 0.9(7.5) = 11.250/0. The dividend at t = 3, $2.00, is expected to grow at 7% for the foreseeable future so the DDM value of Aceler shares at t = 2 is 2 / (0.1125 - 0.07) = 47.06. The t = 0 value of the shares is (47.06 + 1.25) / 1.11252 ©20 15 Kaplan, Inc. = $39.03. Page 325 Self-Test: Equity Investments Page 326 11. A Global registered shares are identical shares of the same issuer that trade on multiple global exchanges in the local currencies. 12. B One of the implications of market efficiency is that if markets are semistrong-form efficient, active portfolio management cannot consistently achieve abnormal riskadjusted returns. ©20 15 Kaplan, Inc. FORMULAS yxwvutsrqponmlkjihgfedcbaYVUTSRQPONMKJIFEDCA CF1 IRR: 0 = CFo + (1 + IRR)l pokED CF2 + (1 + IRR)2 . d full '1 pay b ack perlO = years unti recovery CFn ~ CFt +...+ (1 + IRR)n = ~ (1 + IRR)t unrecovered cost at the beginning of the last year + -------------='-----_____:=-----------''---cash flow during the last year PI = PV of future cash flows = 1 + NPV CFo CFo after-tax cost of debt = kd (1 - t) cost of preferred stock = kps = D ps / P cost of common equity: D kce = p. 1 + g o kce = bond yield + risk premium unlevered asset beta: project beta: 1 D ~ASSET= ~EQUITY + ~PROJECT= ~ASSET 1 1+ (l-t)- D (1- t)E E cost of common equity with a country risk premium: kce = Rp + ~[E(RMKT ) - Rp + country risk premium] ©20 15 Kaplan, Inc. Page 327 Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Formulas ak ooi amount of capital at which the component's cost of capital changes b re pOint = weight of the component in the capital structure XQOLFD Q(P-V) degree of operating leverage = ( ) Q P-V -F . EBIT degree of financial leverage = ---EBIT-I degree of total leverage = DOL . b re ak even quantity X %~EBIT %~sales %~EPS %~EBIT %~EPS D FL = --%~sales f al fIXedoperating costs + fIXedfinancing costs 0 s es = price - variable cost per unit . . fixed operating costs operating breakeven quantity of sales =.. . price - variable cost per unit • current assets current ratio = ------current liabilities . k . cash + short-term marketable securities + receivables qUlc ratio = -------------------current liabilities credit sales receivables turnover = ------average receivables number of days of receivables = average receivables 365 receivables turnover average day's credit sales . costof~o~sold Inventory turnover = -------'=-.---average Inventory • average Inventory 365 number of days of inventory = -.------Inventory turnover average day's COGS . purchases payables turnover ratio = ------"-------average trade payables number of days of payables = 365 . payables turnover ratio average payables average day's purchases operating cycle = average days of inventory + average days of receivables Page 328 ©2015 Kaplan, Inc. Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Formulas . average days + average days cash conversion cycle = f . bl o recerva es of inventory average days of payables tnT 0/0 discount == face value - price face value discount-basis yield == 360 face value - price == face value days C 360 face value - price 365 prIce days to maturity . = holding period yield X days = holding period yield X days bond equivalent yield = % discount x 360 360 days 365 days 365 cost of trade credit == where: days past discount ldi 1+ == % discount days past discount -1 1- % discount number of days after the end of the discount period . d end-of-period value Pt + Div t Pt - Po + Div t - 1= -1 = --=--....::...._---=h o Ing perlO return = beginning-of-period value Po Po .. (R1 +R2 +R3 + ... +Rn) arithmetic mean return = -.:;__-..:::...._---=-----~ n geometric mean return = ~(1 + R1)x (1+ R2)X (1 + R3) x ... x (1 + Rn)-l T L:(Rt-~)2 population variance from historical data: 0"2= ~t---,l,--T T _ 2 L:(Rt -R) sample variance from historical data: s2 = ~t---,l=---- _ T-1 n L: {[Rt,l -R1][Rt,2 sample covariance from historical data: correlation: Pl,2 = -R2]} t=l CoVl,2 = ..::.__:..__--------n-1 Cov12 ' 0"1X0"2 ©20 15 Kaplan, Inc. Page 329 Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Formulas standard deviation for a two-asset portfolio: eq uation of the CML: E(R p ) = Rf + E(Rp) = Rf + (E(RM) xpigfDA E(R M) - Rf O"M O"p - Rf) O"p O"M total risk = systematic risk + unsystematic risk A _ I-'i - COVi,mkt _ 2 O"mkt - Pi,mkt O"i O"mkt capital asset pricing model (CAPM): margin call price = Po . . h di d price-weig te In ex = E(Ri) = RFR + f3i[E(Rmkt) - RFR] 1- initial margin 1- maintenance margin sum of stock prices number of stocks in index adjusted for splits L[(price today )(number L of shares outstanding)] market cap-weighted index = -::----'-----------------~ L[(pricebase year) (number of shares outstanding)] x base year index value preferred stock valuation model: Po = D p kp one-period stock valuation model: Po = Dl _...!:..__ + 1 + ke infinite period model: Po Page 330 Dl = -~ ke - g Do x(l+g) ke - g ©2015 Kaplan, Inc. Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Formulas where: Pn = Dn+1 ,and Dn+1 is a dividend that will grow ke -gc at the constant rate of gc forever ROE D1 earnings multiplier: Po _ E1 E1 k-g expected growth rate: g = (retention rate) (ROE) '1' PIE trating = market price per share EPS over previous 12 months di PIE 1ea Ing = market price per share forecast EPS over next 12 months lePIFEB . market value of equity market price per share = -----==-------==-----PIB rano = book value of equity book value per share where: book value of equity = common shareholders' equity = (total assets - total liabilities) - preferred stock . market value of equity market price per share = -----==--------==-----PIS rano = SI total sales . PleF ratio = market value of equity cash flow sales per share market price per share = ------==-----==------ cash flow per share enterprise value = market value of common and preferred stock + market value of debt - cash and short-term investments ©20 15 Kaplan, Inc. Page 331 INDEX BA AzyxwvutsrqponmlkjihgfedcbaTSRPMLKIDCBA ability to bear risk 188 abnormal profit 251 accelerated book build 216 accounting return on equity 267 accounting risk 129 accounts payable management 86 acid-test ratio 79 active invesrment strategy 248 activelymanaged funds 118 active portfolio management 165 adverseselection 208 after-tax cost of debt 28 after-tax nominal return 140 aging schedule 84 allocational efficiency 220 ali-or-nothing orders 214 alternative markets 202 alternative trading systems (ATS) 206 American depository receipts (ADRs) 265 American depository share (ADS) 265 arbitrage 208, 250 arithmetic mean return 137 ask price 212 ask size 213 asset-backedsecurities 204 asset-based models 295,312 audit committee 97 averagedays' sales outstanding 80 averageinventory processing period 80 B bank 115 bank discount yield 83 banker's acceptances 88 basket of listed depository receipts (BLDR) 265 behavioral finance 255 best efforts 216 beta 129, 172 bias 119 bid-ask spread 213 bid price 212 bid size 213 blanket lien 88 block brokers 206 board elections 95 bond equivalent yield 83 bond mutual funds 118 book runner 216 Page 332 book value of equity 266 breakeven quantity of sales 55 break points 35 broker-dealers 207 brokered markets 219 brokers 206 business risk 49 buyout funds 119 c calendar anomalies 253 callable common shares 261 call markets 217 call money rate 210 call option 205 cannibalization 3 capital allocation line (CAL) 151, 161 capital asset pricing model (CAPM) 30, 171 capital budgeting 1 capital components 24 capital market line (CML) 163 capital markets 202 capital rationing 4 cash conversion cycle 81 cash dividends 64 liquidating 64 regular 64 special 64 cash management investment policy 83 characteristic line 170 classesof common equity 102 classifiedboard 95 clearinghouses 209 closed-end funds 118, 254 commercial paper 88 commodities 205 commodity indexes 239 common shares 261 common stock 203 company analysis 286 competitive strategy 286 complete markets 219 component cost of capital 24 confidential voting 100 conflicting project rankings 14 constant growth model 300 constituent securities 229 continuous markets 218 contracts 204 contribution margin 55 ©20 15 Kaplan, Inc. Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Index conventional cash flow pattern 3 convertible bond arbitrage funds 119 convertible preference shares 262 core-satellite approach 192 corporate governance 94 correlation 143 cost leadership (low-cost) strategy 286 cost of debt capital 28, 29 cost of equity capital 30, 268 cost of preferred stock 29 counterparty risk 209 countty risk premium 34 covariance 142 credit default swaps 205 credit risk 128 crossover rate 12 cumulative preference shares 262 cumulative voting 101,261 currencies 204 current ratio 79 custodians 209 cyclical firm 277FD D daily cash position 81 data mining 252 dayorders 214 dealer markets 218 debt securities 202 declaration date 67 decline stage 284 defensive industries 278 defined benefit pension plan 116 defined contribution pension plan 116 degree of financial leverage (DFL) 52 degree of operating leverage (DOL) 50 degree of total leverage (DTL) 53 delta 130 depository bank 264 depository institutions 207 depository receipts (DRs) 264 derivative contracts 202 derivatives risks 130 direct investing 264 disadvan tages of the lRR method 14 discount-basis yield 83 discounted cash flow models 295 discounted payback method 9 diversifiable risk 165 diversification 131 diversification ratio 114 dividend discount modelMD (DDM) 296 dividend displacement of earnings 308 dividend reinvestment plan 217 downside risk 130 duration 130 E earnings surprise 254 economic profits 279 effect of a share repurchase on book value per share 71 efficient frontier 148 efficient market hypothesis (EMH) 250 electronic communication networks (ECNs) 206 embryonic stage 283 endowment 115 enterprise value 295, 311 equal-weighted index 231 equilibrium interest rate 201 equity market-neutral funds 119 equity securities 202, 203 event-driven funds 119 event study 251 exchanges 206 exchange-traded funds (ETFs) 118, 204 exchange-traded notes (E'fNs) 204 ex-dividend date 67 execution step 117 expansion projects 2 experience curve 279 externalities 3 F factoring 88 factor loading 167 factor sensitivity 167 feedback step 117 fidelity bonds 132 fill-or-kill order 214 finance companies 88 financial assets 202 financial derivative contracts 202 financial intermediaries 206 financial leverage 210 financial risk 49 financial risks 128 firm-specific risk 165 fixed-income arbitrage funds 119 fixed income securities 203 float-adjusted market capitalization-weighted index 232 flotation costs 37 forward contract 204 foundation 115 free cash flow to equity (FCFE) 297 free float 231 ©20 15 Kaplan, Inc. Page 333 Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Index fundamental analysis 251 fundamental value 249,294 fundamental weighting 232 futures contract 204MLIHG investment banks 206 investment companies 116 investment constraints 188 investment opportunity schedule 27 investment policy statement (IPS) 117, 186 investor overconfidence 255 G gamma 130 geometnc mean return 138 global depository receipts (GDRs) 264 global macro funds 119 global minimum-vatiance portfolio 148 global registered shares (GRS) 265 good-on-close orders 214 good-on-open orders 214 good-till-cancelled orders 214 Gordon growth model 300 governmental risk 128 gross return 139 growth industries 278 growth stage 283 growth stocks 253 H hedge fund indexes 239 hedge funds 119,204 herding 255 historical data 142 holder-of-record date 67 holding period return (HPR) 137 I immediate-or-cancelorders 214 incremental cash flows 2 independent projects 4 index funds 118 indications of interest 216 indifference curve 149 individual investors 115 industry life cycle 283 industry rotation 274 informational efficiency 219 informationally efficient capital market 248 information cascade 255 initial margin requirement 210 initial public offerings (1POs) 216,254 institutions 115 insurance companies 115, 208 insurance contract 205 internal rate of return (IRR) 6 disadvantages 14 IRR decision rule 7 intrinsic value 249,294 inventory management 85 inventory turnover 80 Page 334 J January effect 253 Jensen's alpha 179 justifiedPIE PIE 307 L legal and regulatory constraints 189 legal risk 129 leverage 49 leveraged buyout (LBO) 263 leveraged position 210 leveraged return 140 leverageratio 211 life-cyclestage 279 lines of credit 88 liquidity 189 liquidity ratios 79 liquidity risk 128 load funds 118 longevity risk 129 long position 209 long/short funds 119 loss aversion 255 M maintenance margin requirement 212 mandatory projects 2 marginal cost of capital (MCC) 24, 35 marginal cost of capital schedule 27, 35 margin call 212 margin loan 210 market anomaly 252 market capitalization-weighted index 231 market float 231 market model 168 market multiple models 295 market-on-close orders 214 market portfolio 162 market risk 128, 165 market risk premium 163 market-to-book ratio 268 market value 249 market value of equity 267 market value-weighted index 234 matrix pricing 29 mature stage 284 minimum-variance frontier 148 ©20 15 Kaplan, Inc. Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Index minimum-variance portfolio 148 model risk 129 momentum effects 253 money market funds 118 money markets 202 money market yield 83 money-weighted rate of return 138 moral hazard 208 mortality risk 129 M-squared 178 mulrifactor models 167 multilateral trading facilities (MTFs) 206 "multiple lRR" and "no IRR" problems 15 multiplier models 295 mutual funds 116, 117, 204 mutually exclusive projectspN4 N net asset value (NAY) 118, 254 net borrowing 298 net operating cycle 81 net present value (NPV) 4 NPY and stock price 16 NPY profile 12 net return 139 no-load funds 118 nominations committee 98 non-cumulative preference shares 262 non-cyclical firm 278 nondiversifiable risk 165 non-financial risks 128 non-participating preference shares 262 number of days of payables 81 number of days of receivables 80 o offer price 212 open-end fund 118 operating breakeven quantity of sales 57 operating cycle 81 operating risk 49 operational efficiency 219 operational risk 128 opportunity costs 3 optimal capital budget 28 option contract 205 order-driven markets 218 order matching rules 218 overreaction effect 253 over-the-counter markets 218 p participating preference shares 262 passive investment strategy 165, 248 payables payment period 81 payables turnover ratio 81 payback period 8 paymen t date 67 paymen ts- in-lieu 210 peer group 278 personal use of company assets 99 physical derivative contracts 202 planning step 117 political risk 128 pooled investments 117, 203 portfolio perspective 114 post-trade transparent 219 predatory pricing 286 preference shares 262 preferred stock 203, 262, 299 present value models 295 pretax nominal return 140 pre-trade transparent 219 price-book value (P/B) ratio 268,306 price-cash flow (P/CF) ratio 306 price-driven markets 218 price-earnings (PIE) ratio 306 price index 229 price multiple approach 306 price multiples based on com parables 306 price multiples based on fundamentals 306 price prioriry 218 price return 229 price-sales (PIS) ratio 306 price versus market value weighting 234 price-weighted index 230, 232 primary capital markets 216 primary dealers 207 primary market 202 primary sources of liquidity 78 principal business activiry 275 private equity funds 119 private investment in public equiry (PIPE) 263 private placement 217 private securities 202 product or service differentiation strategy 286 profitability index 10, 11 project beta 32 project sequencing 4 proxy 261 public securities 202 pure-play method 32 putable common shares 261 put option 205 ©20 15 Kaplan, Inc. Page 335 Book 4 - Corporate Finance, Portfolio Management, and Equity InvestmentsxnedI Index Q qualifications of board members 96 quick ratio 79 quote-driven markets 218R R real assets 205 real estate indexes 239 real return 140 rebalancing 236 receivablesturnover 79 reconstitution 236 regulatory risk 128 related-party transactions 99 relative risk objectives 187 remuneration! compensation committee 98 replacement projects 2 return generating models 167 return index 229 return on equity (ROE) 267 reversestock splits 67 rho 130 rights offering 217 risk-adjusted returns 251 risk-averse 144 risk aversion coefficient 150 risk budgeting 128, 192 risk governance 127 risk management 126 risk management framework 127 risk-neutral 145 risk objectives 187 risk-seeking 145 risk shifting 132 risk tolerance 127 risk transfer 132 s sales risk 49 scenario analysis 130 seasoned offerings 216 secondary financial markets 216 secondary issues 216 secondary market 202 secondary precedence rule 218 securities 203 security charactetistic line 170 security market index 229 security market line (SML) 170 self-insurance 131 semi-strong form market efficiency 250 separately managed account 119 shakeout stage 284 Page 336 share blocking 100 shareowner legal rights 103 share repurchase 68 using borrowed funds 70 Sharpe ratio 177 shelf registration 217 short position 209 short rebate rate 210 short sale 210 short-term funding 87 single-index model 168 size effect 253 solvency risk 128 sovereign wealth funds 116 sovereign yield spread 34 sponsored depository receipt 264 spot markets 202 spreadsheet modeling 287 standard deviation 129 standing limit orders 214 statutory voting 261 stock dividends 65 stock mutual funds 118 stock splits 65 stop-buy 214 stop loss orders 214 stop orders 214 stop-sell order 214 strategic analysis 280 strategic asset allocation 190 strategic groups 279 stress testing 130 strong-form market efficiency 250 sunk costs 2 surety bond 132 sustainable growth rate 302 swap contract 205 switching costs 283 systematic risk 165 T tactical asset allocation 192 tail risk 129,130 takeover defenses 103 target capital structure 26 tax-loss selling 253 tax risk 128 tax situation 189 technical analysis 251 tender offer 68 terminal value 296 time horizon 189 trade pricing rules 218 traditional investment markets 202 ©20 15 Kaplan, Inc. Book 4 - Corporate Finance, Portfolio Management, and Equity Investments Index tranches 204 Treynor measure 179 turn-of-the-year effect 253 rwo-fund separation theorem 151wvu u unconventional cash flow pattern 3 underwritten offering 216 unique circumstances 189 unique risk 165 unsponsored depository receipt 264 unsystematic risk 165 unweighted index bias 235 utility function 149 w warrants 203 weak-form market efficiency 250 weighted average collection period 84 weighted average cost of capital (WACC) 24 willingness to bear risk 188 window dressing 253 working capital 79 v value at risk (VaR) 130 value effect 253 value stocks 253 value-weighted index 231 vega 130 venture capital 263 venture capital funds 120 ©20 15 Kaplan, Inc. Page 337 Notes Notes