Exam Prep - Need To Knows

Question 1

How are the following accounted for under US GAAP & IFRS?
- Interest paid.
- Interest received.
- Dividends received.
- Dividends paid.

Answer 1

• Interest paid: CFO or CFF (IFRS), CFO (US GAAP).
• Interest received: CFO or CFI (IFRS), CFO (US GAAP).
• Dividends received: CFO or CFI (IFRS), CFO (US GAAP).
• Dividends paid: CFO or CFF (IFRS), CFF (US GAAP).

Question 2

What is the CAPM formula and inputs?

Answer 2

CAPM = Risk free rate + beta x (Market return - risk free rate)

Market return - risk free rate = the market risk premium.

CAPM finds the required return for an investment.

Question 3

What is the DDM formula for ordinary and preference dividends and what can dividends be substituted for?

Answer 3

DDM = ∑(Dividend / 1+required return^n) + (Period end stock price / 1+required return^n).

Preferred DDM = Dividend / required return.

Dividends can be substituted for FCFE in the formula, this is also useful for firms that do not pay dividends.

Question 4

What is the formula for the Gordons Growth Model?

Answer 4

Price = Dividend x (1+g) / (required return - growth rate)

GGM assumes dividends are growing constantly into perpetuity and provides a terminal value.

Remember if the dividend begins further in the future e.g. year 4, make sure to discount 4 periods.

Question 5

What is the Treynor ratio?

Answer 5

Treynor ratio = Portfolio return - risk free rate / beta.

Question 6

What is the Jensen measure?

Answer 6

Jensen measure = Portfolio return - CAPM.

Question 7

What is the information ratio?

Answer 7

Information ratio = Portfolio return - Bmk return / standard deviation of surplus returns.

The standard deviation of surplus return is also known as the tracking error or active risk.

I.e. Excess return / st deviation of excess return.

Question 8

What is the Sharpe ratio?

Answer 8

Sharpe ratio = Portfolio return - risk free rate / Standard deviation.

It provides the portfolio return per unit of risk.

Question 9

How do you calculate the Margin Call Price and the Leverage Ratio?

Answer 9

Margin Call Price: Initial stock price x 1 - initial margin / 1 - maintenance margin

Leverage ratio: 1 / initial margin

Question 10

How is interest coverage calculated?

Answer 10

Interest coverage: EBIT / Interest expense

Question 11

How do you calculate FCFF and FCFE?

Answer 11

FCFF: CFO + NCC + Interest x (1-Tax rate) - FCInv - WCInv

FCFE: CFO + NCC - FCInv - WCInv + Net Debt Increase

Adding interest back net of tax, not simply adding back the tax expense.

Question 12

How is portfolio variance calculated using correlation?

Answer 12

Portfolio Variance: Wa² x σa² + Wb² x σb² + 2 x Wa x Wb x ρab x σa x σb

To find the standard deviation simply take the square root of the variance.

Question 13

How is Beta calculated?

Answer 13

Beta = Covariance of asset A return with market return / variance of market return

OR

Beta = Correlation x st dev asset / st dev market.

Question 14

How is the WACC calculated?

Answer 14

WACC = debt weight x debt cost x 1-tax rate + equity weight x equity cost

Question 15

How do you adjust nominal FX rates for inflation, to create real FX rates?

Answer 15

Real FX rate = Nominal fx rate x (CPI base / CPI price)

Base on top, price on the bottom.

If adjusting for a shorter time period, multiply by n / 360.

Question 16

How do you calculate the arbitrage-free forward rate?

Answer 16

Arbitrage-free forward rate = Spot rate x (1+quote ccy interest rate / 1+base ccy interest rate)

Unlike calculating real FX rates, you must put the rates into the formula in the same order they are quoted.

If a county’s interest rate is higher, their forward rate will be higher. If a forward rate is appreciating for a currency, that currency has a lower interest rate against the base currency.

Question 17

How is standard deviation calculated from variance?

How is covariance calculated from standard deviation?

How is correlation calculated from standard deviation?

Answer 17

Standard deviation is the square root of the variance.

Covariance is the standard deviation of two assets multiplied by each other (Sa x Sb).

Correlation is covariance divided by Sa x Sb.

Question 18

How is the growth rate calculated for dividends?

Answer 18

Growth rate = Retention rate x ROE.

1 - the payout ratio will find the retention rate.

Once the growth rate is found and the required return is found using CAPM, you can simply use the DDM or GGM formula to calculate the stock’s present value.

Question 19

How is a P/E ratio calculated based off fundamentals?

Answer 19

P/E = (Dividend / earnings) / (required return - growth rate)

Essentially, Dividend Payout Ratio / (Required Return - Growth Rate).

Question 20

How is the TWR calculated?

Answer 20

TWR is simply the HPR of each year multiplied by each other raised to the power of 1 / n.

Question 21

What are the inputs for the DuPont calculation of ROE?

Answer 21

3 Stage ROE: Asset Turnover x Equity Multiplier x Net Profit Margin.

5 Stage ROE: Asset Turnover x Equity Multiplier x Interest Burden x Tax Burden x Operating Margin.

Question 22

How is a MCWI, PWI and EWI calculated?

Answer 22

MCWI = Current price x #shares / Base price x #shares x beginning index value.

PWI = ∑Stock prices / #stocks.

EWI = Mean of HPRs for each stock.

Question 23

How is the Degree of Operating Leverage and Degree of Financial Leverage calculated?

Answer 23

DOL = %∆Operating profit / %∆Sales

DFL = %∆Net income / %∆Operating profit

Operating Profit = Quantity x (Price - Variable costs) - Fixed costs

Question 24

How is modified duration calculated and how can it be approximated?

Answer 24

Approx ModDur = Price up - Price down / 2 x current price x change in YTM

Duration Gap = Macaulay duration - Investment Horizon.

Question 25

How is Money Duration calculated?

Answer 25

Money Duration = Annual ModDur x full price of bond

Question 26

How can a bond be valued using interpolation?

Answer 26

If you have a 5 year and a 2 year rate, but want to find the 3 year rate. Simply find the difference between the 5 and 2 year rate and multiply this by 1/n.

Question 27

How do you calculate the ∆ bond price adjusting for convexity?

Answer 27

%∆Price = (-Annual ModDur x ∆YTM) + (0.5 x Annual Convexity x ∆YTM^2) Do not forget to enter ModDur as a negative value, or the answer will be incorrect.

Question 28

How can you calculate a credit spread and LGD%?

Answer 28

LGD% = Expected exposure x (1 - recovery rate) Credit spread = Probability of default x LGD% Fair Bond Yield = Benchmark yield + spread.

Question 29

How is the Liquidity spread and credit risk calculated?

Answer 29

Liquidity spread = Bid price - Offer price Credit risk = Yield spread - Liquidity spread

Question 30

How is effective convexity calculated?

Answer 30

Effective Convexity = Price down + Price up - 2 x Original price / ∆Curve^2 x Original price

Question 31

How is Key Rate Duration calculated?

Answer 31

Key Rate Duration = Modified duration x Weight of bond in portfolio KRD measures the effects of non parallel shifts in the yield curve

Question 32

What are G, I and Z spreads and how are they calculated?

Answer 32

G spread = Corporate bond yield - Interpolated benchmark bond yield (with same maturity). I spread = Corporate bond yield - MRR (excess return measure). Z Spread = (aka Static spread) is the figure that is added to each period’s spot rate, used to discount bonds to PV.

Question 33

What are the 3 tax rates and how are they calculated?

Answer 33

Effective tax rate = Income Tax Expense / Pretax Income. Cash tax rate = Cash Tax Paid / Pretax Income. Statutory tax rate is simply the corporate income tax rate in the country of domicile, however pretax income multiplied by the statutory tax rate doesn’t necessarily equal the income tax expense.

Question 34

How is income tax expense calculated and how does it link to tax payable, DTAs and DTLs?

Answer 34

Income Tax Expense = Income Tax Payable + ∆DTL - ∆DTA. Accounting profit is EBT and this is multiplied by the tax rate to find the income tax payable. DTAs and DTLs are reported separately not offset, IFRS always reports them as non current, US GAAP splits into current & non-current. Valuation allowances are to absorb DTAs that are expected not to fully reverse.

Question 35

What are the main activity ratios and how are they calculated?

Answer 35

Fixed Asset Turnover = Revenue / Average Net Fixed Assets (Net of Dep.). Total Asset Turnover = Revenue / Average Total Assets. Working Capital Turnover = Revenue / Average Working Capital. Working Capital = Current Assets - Current Liabilities.

Question 36

How is the CCC calculated and what are the component ratios?

Answer 36

CCC = DOH + DSO - DPO The CCC is a Liquidity Ratio. Days Payables on Hand = 365 / Payables Turnover. Days of Sales Outstanding (DSO) = 365 / Receivables Turnover. I.e. average number of days it takes customers to pay. Day of Inventory on Hand (DOH) = 365 / Inventory Turnover.

Question 37

What are the main liquidity ratios and how are they calculated?

Answer 37

Defensive Interval Ratio = Cash + Receivables + Short-term Marketable Investments / Daily Cash Expenditure. Current Ratio = Current Assets / Current Liabilities. Quick Ratio = Cash + Receivables + Short-term Marketable Securities / Current Liabilities. Cash Ratio = Cash + Short-term Marketable Securities / Current Liabilities.

Question 38

How is inventory valued under IFRS and US GAAP, excluding firms following LIFO or retail inventory cost methods?

Answer 38

IFRS & US GAAP: Inventory is valued at the lower of Cost or NRV. NRV = Selling price - cost of completion - selling costs. IFRS allows reversals of write downs but US GAAP does not allow reversals.

Question 39

How is inventory valued for US GAAP firms following LIFO and Retail Inventory Cost methods?

Answer 39

US GAAP firms following LIFO or Retail Inventory Cost methods are valued at lower of NRV lower bound or Cost (if not below NRV lower bound). Upper limit = NRV. Lower limit = NRV - Normal Profit Margin. (NRV being the selling price minus selling costs)

Question 40

How are Financial Instruments treated under US GAAP and IFRS, excluding IFRS exceptions?

Answer 40

Historical Cost: Loans, notes receivable, unlisted securities if FV unknown. Amortised Cost: Debt held to maturity. Fair Value: Trading securities, available for sale, derivatives.

Question 41

Which financial instruments under IFRS fall under FV OCI or FV P/L?

Answer 41

Fair Value OCI: Debt securities to be sold before maturity, equity securities. Fair Value P/L: Debt securities to be sold near term, equity securities, derivatives. IFRS firms may make a choice to value any financial assets at Fair Value through P/L.

Question 42

How is the MAD & CV calculated

Answer 42

MAD = ∑Deviations from mean / n. *Ignore negative signs. CV = St Dev / Mean. *Measures variability around a certain point. Positively skewed distribution: Mode < Median < Mean. The mean is pulled in the direction of the skew.

Question 43

What do Kurtosis, Leptokurtic, Mesokurtic and Platykurtic represent?

Answer 43

Kurtosis measures the degree of skewness/peakedness. Mesokurtic: Normal distribution. Leptokurtic: Peaked distribution. Platykurtic: Flatter distribution.

Question 44

What is the Bayes formula?

Answer 44

Bayes = Probability of new info / unconditional probability of new info x prior probability of event.

Question 45

Describe the different sampling methods: - Stratified. - Systematic. - Bootstrap. - Jackknife.

Answer 45

Stratified sampling uses classifications to split the population into smaller groups where a random sample is taken and then pooled. Systematic sampling selects every nth value. Bootstrap takes repeated samples from the dataset and calculates the standard error of the sample mean, it is more computationally demanding Jackknife sampling calculates multiple sample means with one value removed, the standard deviation of these sample means is used as an estimate for the standard error of sample means.

Question 46

How is Roy’s Safety-First Criterion calculated and what is a significance and confidence level?

Answer 46

Roy’s Safety-First Criterion = Portfolio Return - Threshold return (or shortfall) / St Dev of portfolio returns. *This measures the probability the portfolio falls below minimum acceptable levels. In hypothesis testing the significance level is the error rate and the confidence level is the pass rate (1- significance level).

Question 47

How are receivables, payables and inventory turnover calculated?

Answer 47

Receivables Turnover = Revenue / Accounts Receivables. Inventory Turnover = COGS / Average Inventory. Payables Turnover = COGS / Average Trade Payables.

Question 48

What do Delta, Vega, Rho, Theta and Gamma represent?

Answer 48

Delta = Price of underlying. Gamma = Rate of change of delta. Theta = Impact of time remaining. Vega = Impact of volatility. Rho = Impact of interst rates.

Question 49

How are commodities valued?

Answer 49

Cost of carry + risk free rate - convenience yield. If the convenience yield is zero or negative the market will be in contango as the futures price will be greater than the spot. A high convenience yield will lower the futures price.

Question 50

What is the HHI, what is considered low - high and how is it calculated?

Answer 50

HHI = ∑squared %market shares (no need to decimalise). Less than 1,500 is LOW. 1,500 - 2,500 is MODERATE. Greater than 2,500 is HIGH.

Question 51

How can you calculate a future spot rate from forward rates?

Answer 51

Compound the forward rates up to the year you need, then raise them to the power of 1/n. E.g. the 3 year spot = 0y1y x 1y1y x 2y1y ^(1/3).

Question 52

How is basic and diluted EPS calculated?

Answer 52

Basic EPS = Net Income - Pref Dividends / Weighted avg. shares. Diluted EPS = Net Income - Pref Dividends + Conv Debt Interest (net of tax) + Conv Pref Dividends / Weighted avg. shares + Conv Pref shares + Conv Debt Shares + Stock Option Shares. *Stock options only converted if in the money.

Question 53

How are DTLs calculated?

Answer 53

DTL = (Carrying value - Tax base) x Statutory rate.

Question 54

How is leveraged return calculated?

Answer 54

Leveraged return = Total Return x (Equity + Debt) - (cost of debt / Equity)

Question 55

What do Level 1, 2 & 3 valuations represent?

Answer 55

Level 1 assets trade in active markets with quotes readily available. Level 2 assets do not have readily available quotes but can be valued based on direct or indirectly observable inputs. Level 3 assets require unobservable inputs to establish a fair value. Level 1 easy to value, level 3 hard to value.

Question 56

How is effective duration calculated?

Answer 56

Effective Duration = Price down - Price up / 2 x Original price x ∆Curve Effective duration is used for callable and puttable bonds.