## Market Efficiency and Anomalies

This topic review is fairly straightforward. Know the limitations to the claim that market prices should be perfectly efficient, and know the limitations on arbitrage as a mechanism for forcing securities prices to their informationally efficient levels. Know the main reasons that research evidence suggesting anomalous returns behavior may suffer from bias. LOS 55.a Explain the three limitations to achieving fully efficient markets. There are three primary limitations on the market's ability to...

## Info

Di (ke-gc) 2.10 (0.12-0.05) 30.00 This example demonstrates that the stock's value is determined by the relationship between the investor's required rate of return on equity, kt, and the projected growth rate of dividends, g . Notice the critical relationship between k and gc As the difference between k and gc widens, the value of the stock falls. As the difference narrows, the value of the stock rises. Small changes in the difference between ke and gc cause large changes in the stock's value....

## Security Market Indexes

Stock market index series are used to measure the performance of markets, as benchmarks to evaluate portfolio performance, and as a proxy for the overall market in academic studies. It is important for you to know how price-weighted, value-weighted, and equal-weighted indexes are constructed and the potential biases of each method. Be familiar with the major indexes and learn a couple of the problems with constructing bond indexes. Security market indexes are used in the following areas of...

## Concept Checkers

Which of the following least accurately describes the advantages and disadvantages of valuation with the P E multiple A. Advantage P E differences are significantly related to long-run average stock returns. Disadvantage The volatile, transitory portion of earnings makes the interpretation of P Es difficult for analysts. B. Advantage Earnings power is the primary determinant of investment value. Disadvantage Management discretion within allowed accounting practices can distort reported...

## An Introduction to Security Valuation and Industry Analysis

To estimate the market value of any investment, find the present value of its future cash flows estimate the number and dollar amount of future cash flows, estimate when they will be received and what form they will take, and discount these cash flows to the present using the required rate of return. The required return on any investment is the real rate of interest plus premiums for inflation and risk. To make an investment decision, compare the estimated value of the security to its current...

## Self Test Equity Investments

An investor purchased 550 shares of Akley common stock for 38,500 in a margin account and posted initial margin of 50 . The maintenance margin requirement is 35 . The price of Akley, below which the investor would get a margin call, is closest to 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...

## Introduction to Price Multiples

This review covers the estimation of several market-based price multiples. Specifically, this review addresses the pros and cons of using the price-to-earnings ratio, price-to-book value ratio, price-to-sales ratio, and the price-to-cash flow ratio. You should be familiar with the advantages and drawbacks of each of these price multiples. You should also know how to compute each of these multiples, given the relevant market and firm financial information. As you read the material, remember that...

## LOS 46b Compare a companys liquidity measures with those of peer companies

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 short-term liabilities. The current ratio is the best-known measure of liquidity The higher the current ratio, the more likely it is that the company will be able to pay its...

## Profitability Index PI

The profitability index PI is the present value of a project's future cash flows divided by the initial cash outlay. As you can see, the profitability index is closely related to the NPV. The PI is the ratio of the present value of future cash flows to the initial cash outlay, while the NPV is the difference between the present value of future cash flows and 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...

## Choice of the proper cash flows

The capital budgeting process involves five key principles 1. Decisions are based on cash flows, 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. Since these costs are not affected by the accept reject decision, they should not be included in the analysis. An...

## An Introduction to Portfolio Management

This topic review looks at Markowitz portfolio theory and optimal portfolio choice. The major result is the development of the efficient frontier. Understanding the relationship between portfolio risk and correlation is the key to understanding modern portfolio theory. Be able to discuss diversification, correlation, indifference curves, expected return, and the efficient frontier. A sound grasp of the portfolio theory presented here is essential to an understanding of the capital market theory...

## The Asset Allocation Decision

There is nothing difficult here, but the material is important because it is likely to be tested and it is the foundation for the portfolio construction material at Level 2 and especially Level 3. You should be ready to explain the what and why of an investment policy statement and know the objectives risk and return and the constraints liquidity, legal, time horizon, tax treatment, and unique circumstances. Know the four common return objectives, why the objectives part of the investment...

## I3 h I

The curved lines, Ip I2, and 1 , represent indifference curves because all investments combinations of risk and expected return that lie along each curve are equally preferred. Because we have a good expected return and a bad risk , a higher or more preferred indifference curve lies in the northwest direction more expected return and less risk . Focusing on indifference curve Ij, a risk-averse investor whose preferences are represented by these curves will be equally happy with, or indifferent...

## L IRRg l IRRB2 l IRRBy 1 IRRb

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 for Project A and 11.7906 for Project B. Cross-Reference to CFA Institute Assigned Reading 44 - Capital Budgeting With the HP 12C, the IRR can be calculated with Both projects should be accepted because their IRRs are greater than the 10 required rate of return.

## Answers Concept Checkers

B 0.5 x 0.2 0.25 x 0.1 0.25 x-0.1 0.1, or 10 2. B 0.5 0.2 - 0.1 2 0.25 0.1 - 0.1 2 0.25 -0.1 - 0.1 2 0.005 0 0.01 0.015 4. 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 5 . A portfolio of these two assets will have a positive variance unless their portfolio weights are those that minimize the portfolio variance. Covariance is equal to the correlation coefficient times the product of...

## Financial Statement Analysis

This review demonstrates the basic methodology for deriving pro forma financial statements for a company based on a forecast of next period sales. While there are innumerable assumptions and forecasts that can be used in preparing pro forma financial statements, we illustrate the basic methodology under a set of fairly straightforward assumptions. LOS 47 Demonstrate the use of pro forma income and balance sheet statements. Pro forma is from the Latin and means as a matter of form. Pro forma...

## Caffeine Plus And Sparklin S

0.255 Cov 0.255 5 0.0510 Correlation. The magnitude of the covariance depends on the magnitude of the individual stocks' standard deviations and the relationship between their co-movements. The covariance is an absolute measure and is measured in return units squared. Covariance can be standardized by dividing by the product of the standard deviations of the two securities being compared. This standardized measure of co-movement is called The term p 2 is called the correlation coefficient...

## Factors That Influence a Companys 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. 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...

## Self Test Corporate Finance

Based on the NPV profiles for two potential capital projects of the same risk class shown in the figure above, which of the following statements is least likely correct A. The IRR of Project A is less than that of Project B. B. If the projects are independent and the cost of capital is 15 , both projects should be accepted. C. At some discount rate less than 15 the expected increase in firm value from undertaking Project A is exactly the same as the expected increase from Project B. 2. Which of...

## LOS 46f Assess the performance of a companys accounts receivable inventory management and accounts payable functions

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 000's Figure 1 Receivables Aging 000's In March, 200,000 of accounts receivable were current that is, had been outstanding...

## Example Determining target capital structure weights

The market values of a firm's capital are as follows Debt outstanding 8 million Preferred stock outstanding 2 million Common stock outstanding 10 million Total capital 20 million What is the firm's target capital structure based on its existing capital structure preferred stock 10 , wps 0.10 common stock 50 , wce 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 45.d...

## Payback Period

The payback period PBP is the number of years it takes to recover the initial cost of an investment. Calculate the payback periods for the two projects that have the cash flows presented in Table 1. Note the Year 0 cash flow represents the initial cost of each project. Note that the cumulative net cash flow 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. Year...

## Calculating a Companys Weighted Average Cost of Capital

WACC wd kd l - t w k wce kce WACC wd kd l - t w k wce kce S ppose Dexter, Inc.'s target capital structure is as follows wd 0.45, wps 0.05, and wce 0.50 Its before-tax cost of debt is 8 , its cost of equity is 12 , its cost of preferred stock is 8.4 , and its marginal tax rate is 40 . Calculate Dexter's WACC. WACC wd kd l - t wps kps wce kce WACC 0.45 0.08 0.6 0.05 0.084 0.50 0.12 0.0858 8.6 LOS 45.c Describe alternative methods of calculating the weights used in the WACC, including the use of...

## LOS 44e Explain the NPV profile compare and contrast the NPV and IRR methods when evaluating independent and mutually

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 NPVs are plotted on the y-axis. Note that the projects' IRRs are the discount rates where the NPV profiles intersect the x-axis, since these are the discount rates for...

## 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. 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...

## LOS 44a Explain the capital budgeting process including the typical steps of the process and distinguish among the

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...