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# CFA 2018 Level 2 CFA Level II Quick Sheet

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CRITICAL 2018

CONCEPTS ®CFA EXAM REVIEW

FOR THE CFA EXAM ®

CFA LEVEL II SMARTSHEET ®

FUNDAMENTALS FOR CFA EXAM SUCCESS W CID184

Standard error of the estimate (smaller SEE indicatesMulticollinearity: two or more independent variables

Makes regression coeﬀ icients inaccurate and t-test>Diﬀ icult to isolate the impact of each independent variable on the dependent variable. Model speciﬁ cation erPrediction interval around the predicted value of theMisspeciﬁ ed functional form (omitting important

Time-series misspeciﬁ cation (including lagged

MSR MSE RSS SSE = = = =

( ) ( ) j ( ) ( ) b t b t ( ) ( ) ( ) ( ) b t b t ( ) ( ) t ( t (

Estimated regression coefficient H − ypothesized value of regression coefficient Standard error of regression coefficient

are simultaneously equal to zero (use a one-tailed F-test and reject null hypothesis if F-statistic > F

crit

)

Source of Variation degrees of Freedom Sum of Squares

Mean Sum of Squares F Significance

Regression k RSS MSR = RSS / k MSR/MSE p‐value Residual n − (k + 1) SSE MSE = SSE /n − (k + 1) total t t n − 1 SSt

F k n k

regression can be used to test the relationships

t j c ( ) ( ) b t b t ( ) ( ) b

/ /[ ( ) n k n k − + n k n k ] ( ) ( )

from the ANOVA table

2

indicates a higher proportion of the total variation in dependent variable explained by the independent variables)

R 2

= Total variatio ar ar n U − nexplained variatio ar ar n

Total va v v ri va ation SST SSE SST RSS SST

= −

n k n k

INDEPENDENT VARIABLES)

ˆ ( ) estimated regression coefficient (critical cr -value)(coefficient standard tanda tanda error) ( ) ( ) b t ( ) ( ) ( )

1

n n n n

= =

i = = 1

dependent variable

s s n n s f s s s s x 2 2 2 2

1

Y t s c f Y s t Y t MULTIPLE REGRESSION (2 OR MORE

1 = +

1 = +

s s s s 2 2

= + = +

( ) ( ) n s n s 1 n s n s n s n s

( ) ( ) −

ˆ

=

1

2 Adjusted Ad

) t s t s ) 0 if −

= = = =

b b t

covariance stationary (undeﬁ ned mean reverting level)

x x t s t t x x x x t t t t s

, E t t t t ( ) t t t t 0, E( ) , t t t t E( t t t t ) 0 if 1 2 2 ) , ) , = +

x x x x t t x x 1 ε ε t t

, E t t t t ( ) ( ) t t t t t t = ε 0, E( ) , ) , t t t t ) , ) , ε ε t t t t = ≠

covariance stationary (mean reverting level of 0)

1

y x x x x t s t t y x y x t t x x x x t t x t x t t t x t x t t t x t x t s

, E x t x t t t t t

x t x t ( ) x t x t t t t t x t x t 0, x t x t E( x t x t ) , x t t t t t x t E( x t x t t t t t

) x t x t fo x t x t x t x t 1 1

x x x x t t t t x x x x 1 x t x t 2 2 x t x t ) , ) , x t x t x t = − y x y x = + x x x x 1 1 x x x x t t x x ε − t t = ε x t x t ε = x t x t ( ) x t x t x t t t t t x t x t x t ε = x t x t t t x t x t x t x t x t t t t t x t x t x t x t x t x t x t x t t t t t x t x t x t x t t t t t t t x t x t x t x t x t t t t t x t x t x t x t x t ε = x t x t s x t x t ) x t x t x t ≠ t t t t 1 1 1 1 t t t t −

of the error term will be signiﬁ cantly diﬀ erent from 0 (can be solved by introducing a seasonal lag in the model).

of the error in one period depends on the variance of the error in previous periods (if ARCH errors are found, use generalized least squares to correct for heteroskedasticity)

test to determine whether the independent variable and the dependent variable have a unit root

1 x

Mean revertin ver ver g level

1

variables; variables may need to be transformed; pooling data incorrectly).

1 (1 ) 2 2 2 2 2 R R 2 2 2 2 n n k

R = = R R R R −

− − − n k n k

−

VIOLATIONS OF REGRESSION ASSUMPTIONS

(or combinations of independent variables) are highly correlated

for the signiﬁ cance of each regression coeﬀ icient unreliable.

dependent variables as independent variables in regressions when there is serial correlation of errors; including an independent variable that is a function of the dependent variable; measuring independent variables with error; nonstationarity).

= = −

TIME SERIES ANALYSIS

y b b t t T t t b t t t y b y b = + y b y b t t y b + = t T t T t t t t 1 b t b t 1 t t t t b t b t = + = + t t t t t t 1 2 t T t T t t t t + = + = t t t t , , t T t T + = + = t T t T t T t T , . . . t T t T , t T t T

variable exhibits exponential growth ln , 1,2, . . . , 1 y b b t 1 1 t T , 1,2, . . . , 1 , t t 1 y b y b b t 1 1 = + 1 1 y b y b t t 1 1 y b + ε t t t t , 1 ,

1

of the dependent variable to predict its current value

such that the error terms do not exhibit serial correlation and heteroskedasticity in order to be used for statistical inference.

t-stat =

Residual autocorrelation for n f n f lag Standa d d rd da error of residual a esidua esidua utocorrelation

∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑

Conﬁ dence interval for regression coeﬀ icients: use n – (k

1) degrees of freedomLinear trend model: predicts that the dependent variable grows by a constant amount in each periodLog-linear trend model: predicts that the dependentHypothesis test on each regression coeﬀ icient: use n – (k

1) degrees of freedom = t-statAutoregressive (AR) time series model: uses past valuesp

value: lowest level of signiﬁ cance at which we can reject the null hypothesis that the population value of the regression coeﬀ icient is zero in a two-tailed test (the smaller the p-value, the weaker the case for the null hypothesis)First-order AR model 1 1 x b b x 1 1 t t 1 x b x b b x = + 1 1 t 1 1 x b x b t t 1 1 x b + ε −AR model must be covariance stationary and speciﬁ ed

• ANOVA table for testing whether all the slope coeﬀ icients

A. Disclosure of Conﬂ icts

C. Responsibilities of Supervisors

V. Investment Analysis, Recommendations and Actions

A. Diligence and Reasonable Basis

B. Communication with Clients and Prospective Clients

C. Record Retention

VI. Conﬂ icts of Interests

C. Referral Fees

B. Priority of Transactions

A. Loyalty

VII. Responsibilities as a CFA Institute Member or CFA Candidate

A. Conduct as Participants in CFA Institute Programs

B. Reference to CFA Institute, the CFA Designation, and the CFA Program

RESEARCH OBJECTIVITY STANDARDS

1.0 Research Objectivity Policy

2.0 Public Appearances

B. Additional Compensation Arrangements

Preservation of Conﬁ dentiality

IV. Duties to Employers

4.0 Investment Banking

efficientlearning.com/cfa ETHICAL AND PROFESSIONAL STANDARDS STANDARDS OF PROFESSIONAL CONDUCT

I. Professionalism

A. Knowledge of the Law

B. Independence and Objectivity

C. Misrepresentation

D. Misconduct

II. Integrity of Capital Markets

A. Material Nonpublic Information

B. Market Manipulation

III. Duties to Clients

A. Loyalty, Prudence and Care

B. Fair Dealing

C. Suitability

D. Performance Presentation E.

∑ ∑ ∑ ∑

t

test for serial (auto) correlation of the error terms (model is correctly speciﬁ ed if all the error autocorrelations are not signiﬁ cantly diﬀ erent from 0)stat

• Standard error of the estimate (SEE) = √MSE using MSECoeﬀ icient of determination (higher R

Mean-reverting level of AR(1) model

3.0 Reasonable and Adequate Basis

5.0 Research Analyst Compensation

n n

2 i n i i n

∑ ∑

( ˆ ˆ

) 1 2 Y b b X 1 1 i i 1 Y b Y b b X 1 1 =

∑ ∑ ∑ ∑ Y b Y b n n n n

∑ ∑ ∑ ∑

2 (ˆ )

∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑

n n n n

= ε

−

6.0 Relationships with Subject Companies

2 1 1/2 2 1 1/2

ˆ ˆ

better ﬁ t of regression model) SEE

Random walk is a special of the AR(1) model that is notFirst diﬀ erence of a random walk in order to make it

7.0 Personal Investments and Trading

8.0 Timeliness of Research Reports and Recommendations

9.0 Compliance and Enforcement

10.0 Disclosure

Adjusted R

11.0 Rating System

AR(1) model has a unit root if the slope coeﬀ icient equals 1, e.g. a random walk. Dickey-Fuller test indicates that a time series has a unit root if the null hypothesis is not rejected. Seasonality in AR models: the seasonal autocorrelation

QUANTITATIVE METHODS CORRELATION AND REGRESSION (1 INDEPENDENT VARIABLE)

Sample correlation coeﬀ icientHeteroskedascity: variance of error term is not constantUnconditional: heteroskedasticity is not related to the independent variables (does not aﬀ ect statistical inference).ARCH models: used to determine whether the variance

r

= =

r

Conditional: heteroskedasticity is correlated with the independent variables (causes F-test for overall signiﬁ cance of the regression and t-test for the signiﬁ cance of each regression coeﬀ icient to become unreliable).Testing the signiﬁ cance of the correlation coeﬀ icientRegression with two time series: use the Dickey-Fuller

= = −

− Test-stat

2

1

2 t

= = = =

r n r n r n = Number of observations r = Sample correlation n – 2 = Degrees of freedom

Sample correlation coefficient Cov(X,Y) s s X Y s s s sSerial correlation: regression errors are correlated across observations (could be positive or negative and has same eﬀ ect on statistical inference as conditional heteroskedasticIf neither of the time series has a unit root, linear Fisher and international Fisher eﬀ ects: if there is real

Endogenous growth model Capital is broadened to include human and knowledge capital and R&D. R&D results in increasing returns to scale across the entire economy. Saving and investment can generate self-sustainingIf either of them has a unit root, linear regression cannot be used as results may be spurious. If both of them have unit roots and if they are

interest rate parity, the foreign-domestic nominal yield spread will be determined by the foreign-domestic expected inﬂ ation rate diﬀ erential

which the client can sell currency b (base currency) to the dealer. The ask price is the price at which the client can buy currency b from the dealer.

a format such that the common (or third) currency cancels out if we multiply the exchange rates

JPY EUR JPY USD USD EUR = × = × • Multiply bid prices to obtain the cross-rate bid price.

dependent upon countries having the same savings rates, population growth rates and production functions.

output per capita in developing countries will eventually converge to the level of developed countries.

growth at a permanently higher rate as the positive externalities associated with R&D prevent diminishing marginal returns to capital.

increase in domestic money supply will lead to depreciation of the domestic currency.

(assumes output is ﬁ xed)

ECONOMICS

(increase) aggregate demand, resulting in an increase (decrease) in net exports. This will cause the domestic currency to appreciate (depreciate).

(increase) aggregate demand, resulting in an increase (decrease) in net exports. This will cause the domestic currency to appreciate (depreciate).

ﬂ ows dominate)

both expansionary, the overall impact on the exchange rate will be unclear.

ﬂ oating exchange rates will result in depreciation (appreciation) of the domestic currency.

ﬂ oating exchange rates will result in appreciation (depreciation) of the domestic currency.

currencies and short positions in low-yield currencies (return distribution is peaked around the mean with negative skew and fat tails)

a/b , i.e. number of units of currency a (price currency) required to purchase one unit of currency b (base currency). USD/GBP = 1.5125 means that it will take 1.5125 USD to purchase 1 GBP

RISK TYPES AND PROBABILISTIC APPROACHES Discrete/ Continuous Correlated/ Independent Sequential/ Concurrent Risk Approach Discrete Correlated Concurrent Scenario analysis Continuous Either Either Simulations

Fischer Effect: i = r + π r e

FX carry trade: taking long positions in high-yield

Convergence • Absolute: regardless of their particular characteristics,

Mundell-Fleming model with high capital mobility

• A restrictive (expansionary) monetary policy underConditional: convergence in output per capita isA restrictive (expansionary) ﬁ scal policy underConvergence should occur more quickly for an open economy.CURRENCY EXCHANGE RATES

• If monetary and ﬁ scal policies are both restrictive orExchange rates are expressed using the conventionECONOMICS OF REGULAT ION

• Mundell-Fleming model with low capital mobility (tradeEconomic rationale for regulatory intervention: informational frictions (resulting in adverse selection and moral hazard) and externalities (free-rider prob

• A restrictive (expansionary) monetary policy will lowerExchange rates with bid and ask prices For exchange rate a/b, the bid price is the price atRegulatory tools: price mechanisms (taxes andA restrictive (expansionary) ﬁ scal policy will lower

Regulatory interdependencies: regulatory capture,>The b/a ask price is the reciprocal of the a/b bid price. The b/a bid price is the reciprocal of the a/b ask price. Cross-rates with bid and ask prCosts of regulation: regulatory burden and net regulatory

• If monetary and ﬁ scal stances are not the same, the overall impact on the exchange rate will be unclear. Monetary models of exchange rate determinationSunset provisions: regulators must conduct a new cost-Bring the bid‒ask quotes for the exchange rates into

• Monetary approach: higher inﬂ ation due to a relative

burden (private costs – private beneﬁ ts)

beneﬁ t analysis before regulation is renewed

cointegrated, the regression coeﬀ icients and standard errors will be consistent and they can be used to conduct hypothesis tests.

subsidies), regulatory mandates/restrictions on behaviors, provision of public goods/ﬁ nancing for private projects

regulatory competition, regulatory arbitrage

efficientlearning.com/cfa

between the two time series.

International Fisher effect: (i FC − i DC ) = (π e FC − π e DC )FINANCIAL REPORTING AND ANALYSIS

• Dornbusch overshooting model: in the short run, anMultiply ask prices to obtain the cross-rate ask price. Triangular arbitrage is possible if the dealer’s cross-rateInvestments in ﬁ nancial assets (usually < 20% interest)

Marking to market a position on a currency forward Create an equal oﬀ setting forward position to the initial forward position. Determine the all-in forward rate for the oﬀ setting forward contract. Calculate the proﬁ t/loss on the net position as of the settlement date. Calculate the PV of the proﬁ t/loss. Covered interest rate parity: currency with the higher

• Growth accounting equation (based on Cobb-DouglasFair value through proﬁ t or loss (held for tradingLabor productivity growth accounting equationAvailable-for-sale (AFS): initially recognized at fair

Classical growth model (Malthusian model)

and investments designated at fair value): initially recognized at fair value, then remeasured at fair value with unrealized and realized gains/losses, interest income and dividend income reported in income statement.

bid (ask) price is above (below) the interbank market’s implied cross-rate ask (bid) price.

under IAS 39

Held-to-maturity (debt securities): reported atECONOMIC GROWTH

amortized cost using the eﬀ ective interest method; interest income and realized gains/losses are recognized in income statement.

value, then remeasured at fair value with unrealized gains/losses recognized in equity (other comp. income) while realized gains/losses, interest income and dividend income are recognized in income statement.

× × BC × ( ) ( ) Actual 360 ( ) PC + × + × PC ( + × + × ( ) ( ) × + ×

Growth in real GDP per capita is temporary: once

× + × ll 360) Forward premium (discount) as a % F S S PC F S F S /B F S F S C P F S F S C/BC PC/BC = F S F S

Diﬀ erence between IFRS and US GAAP: unrealized>

• In the long run, new technologies result in a larger (but not richer) population. Neoclassical growth model (Solow’s moInvestments in ﬁ nancial assets under IFRS 9 • All ﬁ nancial assets are initially measured at fair value. Debt instruments are subsequently measured atUncovered interest rate parity: expected appreciation/Both labor and capital are variable factors of

gains/losses on AFS debt securities arising from exchange rate movements are recognized in income statement under IFRS (other comp income under US GAAP).

amortized cost, fair value through other comp income (FVOCI) or fair value through proﬁ t or loss (FVPL).

• In the steady state, both capital per worker and output

Equity investments held for trading must be measuredRelative purchasing power parity: high inﬂ ation leads to

• Marginal product of capital is constant and equal to the real interest rate.

• Capital deepening has no eﬀ ect on the growth rate ofInvestments in associates (20-50% interest, signiﬁ cant

π π Investment is initially recognized on the investor’s efficientlearning.com/cfa

at FVPL; other equity investments can be measured at FVPL or FVOCI.

inﬂ uence): use equity method

balance sheet at cost (within a single line item);

risk-free rate will trade at a forward discount

F S

depreciation of the currency oﬀ sets the yield diﬀ erential

T 1 FC/DC ) S FC/DC FC DC T ) S ) S

1

Relative PPP: E(S ) S

currency depreciation

1 DC + ( ) ( ) ( ) ( )

1 FC + ( )

S S FC S S S S /D S S S S C S S S S e S S S S FC/DC FC DC = × S S S S FC/DC ( )

i

per worker are growing at the same rate, θ /(1 – α), where θ is the growth rate of total factor productivity and α is the elasticity of output with respect to capital.

1 Actua PC F S F S /B F S F S C P F S F S C/BC PC BC = × F S F S C P F S F S C/BC

1 Actual 360

increase in domestic money supply will lead to higher inﬂ ation and the domestic currency will decline to a level lower than its PPP value; in the long run, as domestic interest rates rise, the nominal exchange rate will recover and approach its PPP value.

∆ ∆ ∆ ∆ production function)

Y/ ∆ ∆ ∆ ∆ Y A ∆ ∆ ∆ ∆ /A Y A/A ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆

L/L L/ L/ = + Y A ∆ ∆ ∆ ∆ /A Y A Y A ∆ ∆ ∆ ∆ α α ∆ ∆ K/ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ( ) ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ α α α α ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆

Growth rate in potential GDP Long-term growth rate of labor force Long-term growth rate in labor productivity =

it rises above the subsistence level, it falls due to a population explosion.

production and suﬀ er from diminishing marginal productivity.

output in the steady state, which is growing at a rate of θ /(1 – α) + n, where n is the labor supply growth rate.

Hyperinﬂ ationary economies • US GAAP: use temporal method.IFRS: (1) restate subsidiary’s foreign currency accounts for inﬂ ation; (2) translate using current exchange rate; (3) gain/loss in purchasing power recorded on income statement.

Investor’s proportionate share of investee earnings is reported within a single item in income statement. Excess of purchase price over book value (if any) is ﬁ rst

• Periodic pension cost calculation (same for IFRS and US

expenses related to nonmonetary assets (e.g. COGS, depreciation) which are translated at historical rates.

Averag = × = × × × × × e A ee sset Average Asset

NI EBT EBT EBIT EBIT Revenue Revenue

ROE Tax Burden Interest burden EBIT margin Tot = × E T E Tax Burden × × n E n EBIT margin T n T al aa asset tur t t nove ur ur r Financial leverage r F r F ROE

INTEGRATED FINANCIAL STATEMENT ANALYSIS

EVALUATING QUALITY OF FINANCIAL REPORTS

Not applicable for IFRS. No effect on periodic pension cost under U.S. GAAP.

Lower periodic pension expense under U.S. GAAP.

Initial investment for a new investment = FCInv + NWCInv

Higher expected return on plan assets No effect, because fair value of plan assets are used on balance sheet

Higher rate of compensation increase Higher obligation Higher service and interest costs will increase periodic pension cost and pension expense.

Assumption Impact of Assumption on Net Pension Liability (Asset) Impact of Assumption on Periodic Pension Cost and Pension Expense

Higher discount rate Lower obligation Pension cost and pension expense will both typically be lower because of lower opening obligation and lower service costs.

periodic pension cost

periodic pension expense)

Average Equity ×

Initial investment for a replacement project ro FCI = nv n n NWCInv Sal t l B l t l t

Periodic pension cost Current service costs Int = + Current service costs er ee est costs Past service costs

V V

CF (S C D) (l t) D or CF (S C) (l t) tD = − (S − −

C D C D) (l t l t + = D or CF − −

C) (l

TNOCF Sal NWCInv t Sal T T NWCInv t S T = + F S F Sal T T T T − −

T t S ( ) t S t Sal B T T T t S t Sal T − − t S t Sal

inﬂ ation is higher (lower) than expected, the proﬁ tability of the project will be lower (higher) than expec ted

project with higher EAA (annuity payment over the project’s life with same NPV as project’s NPV).

proﬁ tability index (PI) to rank proje cts

R R ) R ] i F R R R R i M F

= + R R R R i F R R R R β − [E(R ) R ) R i M [E(R

expansion), ﬂ exibility, fundamental

Economic income = After‐tax operating cash flow + Change in market value Economic income = After‐tax operating cash flow + (Ending market value − Beginning market value) OR Economic income = After‐tax operating cash flow − (Beginning market value − Ending market value) Economic income = After‐tax cash flows − Economic depreciation

Economic proﬁ t = [EBIT (1 - Tax rate)] - $WACC Economic proﬁ t = NOPAT - $WACC

− −

Ending net pension liability

Periodic pension cost =

GAAP)

Funded status F = air value of plan assets – Pension obligation

investor’s proportionate share of investee earnings (less dividends) increases carrying amount of investment.

allocated to speciﬁ c assets whose fair value exceeds book value: excess related to inventory is expensed while excess related to PP&E is depreciated over an appropriate period of time (investor adjusts carrying amount of investment on its balance sheet by reducing its share of investee proﬁ ts in the income statement) and any remaining amount is treated as goodwill (not amortized but subject to annual impairment test).

– Beginning net pension liability

Employer contributions

Beneish model: the higher the M-score (i.e. the less negative the number) the higher the probability of earnings manipulation

Altman bankruptcy protection model: higher z-score is betterFair value option: unrealized gains/losses arising fromPeriodic pension cost reported in P&L (also known as

changes in fair value as well as interest and dividends received are included in the investor’s income.

IFRS: current service costs, past service costs and net interest expense/income recognized in P&L (remeasurement refers to items in OCI).Joint ventures (shared control): use equity method Business combinations (controlling interest): useROE decomposition (extended DuPont analysis)

acquisition methodUS GAAP: current service costs, interest expense, expected return on plan assets, amortization of past service costs and amortization of actuarial gains and losses recognized in P&L (past service costs and actuarial gains/losses are usually recognized in OCI before subsequent amortization to P&All assets (at fair value), liabilities (at fair value),

revenues and expenses of acquiree are combined with those of parent/acquirer.

Transactions between acquirer and acquiree are eliminated. Acquiree’s equity accounts are ignored. If acquirer owns less than 100% equity interest in

• Impact of key assumptions on net pension liability andCORPORATE FINANCE

acquiree, it must create a non-controlling interest account on consolidated balance sheet and income statement to reﬂ ect proportionate share in acquiree’s net assets and net income that belongs to minority shareholders.

Initial investment outlay New investmentFull goodwill method: goodwill equals the excess

of purchase price over fair value of the acquirer’s proportionate share of acquiree’s identiﬁ able net assets.

of total fair value of acquiree over fair value of its identiﬁ able net assets.

Replacement projectPartial goodwill method: goodwill equals the excess

− NWCInv − l t l t l t l t( ) Sal BV Sa− + − Sal B l B Sal B l B

Annual aft er-tax operating cash ﬂ ows (CF)Goodwill is not amortized but subject to annual impairment test. Diﬀ erence between IFRS and US GAAP: IFRS permits fullMULTINATIONAL OPERATIONS

Terminal year aft er-tax non-operating cash ﬂ ows (TNOCF)For independent subsidLocal currency (LC) = functional currency (FC) ≠ parent’s presentation currency (PC).Inﬂ ation reduces the value of depreciation tax savings: ifImpact of diﬀ erent accounting methods on ﬁ nancialUse current rate method to translate accounts from LC to PC.Income statement at average rate.Mutually exclusive projects with unequal lives Least common multiple of lives approach: choose project with higher NPV. Equivalent annual annuity (EAA) approach: chooseAssets and liabilities at current rate.Capital stock at historical rate.>Dividends at rate when declaTranslation gain/loss included in equity under cumulative translation adjustment (CTA). Exposure = net asse ts.Capital rationing: if budget is ﬁ xed, use NPV orFor well-integrated subsidiary • LC ≠ FC = PC.Project discount rate using CAPM>Use temporal method to translate accounts from LC toMonetary assets and liabilities at current rate.

• Nonmonetary assets and liabilities at historical rate. Capital stock at historical rate.

• Revenues and expenses at average rate, except forReal options: timing, sizing (abandonment andPension obligation componentsEconomic incomeCurrent service costs Interest costs Past service costs Actuarial losses − Actuarial gains − Benefits paid

Dividends at rate when declared.Translation gain/loss reported in income statement.Exposure = net monetary asset or liability.Fair value of plan assetsEconomic proﬁ tNet asset (liability) exposure and appreciating foreign currency = translation gain (loss)Actual return on plan assets Contributions made by the employer to the plan − Benefits paid to employees

ACCOUNTING FOR DEFINED BENEFIT PENSION PLANS

ROA Better (higher) as net income is the same and assets are lower Worse (lower) as net income is the same and assets are higher

Worse (lower) as sales are higher and net income is the same ROE Better (higher) as equity is lower and net income is the same Worse (lower) as equity is higher and net income is the same

Net Profit Margin Better (higher) as sales are lower and net income is the same

Equity Method Acquisition Method Leverage Better (lower) as liabilities are lower and equity is the same Worse (higher) as liabilities are higher and equity is the same

Pension obligation at the beginning of the period

Pension obligation at the end of the period

Fair value of plan assets at the beginning of the period

ratios

and partial goodwill methods (US GAAP requires use of full goodwill metho d).Ratios (originally in LC versus current rate metPure income statement and balance sheet ratios unaﬀ ected.

Fair value of plan assets at the end of the periodClaims valuation Separate cash ﬂ ows available to debt and equity holders.If foreign currency is appreciating (depreciating), mixed ratios (based on year-end b/sheet values) will be smaller (larger) aft er translatBalance sheet liability (or asset) equals funded sta tus Negative funded status = plan is underfunded = net pension liability. Positive funded status = plan is overfunded = net pension asset. Discount them at their respective required rates of

the greatest good for the greatest number of people

BVPS will decrease (increase) aft er repurchase

= V + V T

V A V * = V A

transactions used to estimate fair acquisition price for target (takeover premium built into transaction prices).

measures used to estimate market value of target, then add takeover premium.

Post‐Merger HHI Concentration Change in HHI Government Action Less than 1,000 Not concentrated Any amount No action Between l,000 and 1,800 Moderately concentrated 100 or more Possible challenge More than 1,800 Highly concentrated 50 or more Challenge

services (veil of ignorance and diﬀ erencing principle)

that take precedence over a collective good

never purely as means to the ends of others

FCFE coverage ratio = FCFE / [Dividends + Share repurchases]

on shareholder wealth is the same as that of cash dividends.

Reasons to prefer share repurchase: potential taxAdd PVs of the two cash ﬂ ow streams to calculate total company/asset value.

V A V = Pre‐merger value of the acquirer

advantages, share price support, managerial ﬂ exibility, oﬀ set dilution from employee stock options, higher ﬁ nancial leverage.

Target company valuationCAPITAL STRUCTUREDCF analysis based on FEﬀ ect of share repurchase on EPS If funds used for share repurchase are generatedComparable company analysis: relative valuationMM Prop I without taxes: given MM assumptions and no taxes, changes in capital structure do not aﬀ ect company value

Comparable transaction analysis: recent mergerMM Prop II without taxes: higher ﬁ nancial leverage raises the cost of equity but no change in WACC

• If borrowing used to ﬁ nance share repurchase, EPS will than earnings yield. Aﬀ ect of share repurchase on book value per shareMerger bid evalua tionPost-merger value of the combined company

S – CMM Prop I with taxes: debt results in tax savings, so company value would be maximized with 100% debt (no costs of ﬁ nancial distress)

Dividend safety measureMM Prop II with taxes: higher ﬁ nancial leverage raises the cost of equity and lowers WACC (WACC is minimized at 100% debt)

V A V * = Post‐merger value of the combined companyBUSINESS ETHICS

Takeover premium and acquirer’s gain>Friedman doctrine: only social responsibility is to increase proﬁ ts as long as the company stays “within the rules of the game&rd

• Utilitarian ethics: best decisions are those that produceKantian ethics: people should be treated as ends andAgency costs: using more debt reduces net agency costs

• Rights theories: people have certain fundamental rightsPecking order