As I am put on hold for the Security Analysis book by Benjamin Graham and Dodd, I thought of going through the following

A Modern Approach to Graham and Dodd Investing - By Thomas P. Au

This book can be previewed at google books .link below.

http://books.google.com/books?id=O4xKiTAOxT4C

Per my current reading, the first 2 chapters are basic concepts around financial analysis on value, growth oriented investment analysis factors and how Benjamin and Dodd viewed it and how Warren Buffet has extended those ideas.

Quick takeaway, stock can be viewed very similar to bonds. Just like discount, premiums on bonds ( against par value) determine the yield against current market interest rate, the premium/discount on stocks ( against book value) determines the dividend yield against the dividend distribution rate.

To illustrate, assume book value of stock is $10 per share, $1 is earning for an year and 60 cents paid as dividend. For this scenario

Dividend distribution rate = D/B = $0.6/$10 = 6%

Naturally, the remaining 40 cents or 4% makes the Earnings reinvestment rate.

With the above said, let us assume the price of the stock trades at a discount, say $6, then the dividend yield 10% ($ 0.6/$6) is greater than the Dividend reinvestment yield, thereby forming an analogous comparison to the bond behavior.

## Saturday, December 27, 2008

## Saturday, October 4, 2008

### How good is the Bail Out ?

On 10/03/2008, the $700 Billion bail out/rescue plan passed US Congress ( After the first attempt that failed a week earlier). The bail out probably passed since the issue at hand posed a double edged sword. The still open edge which is 'What has changed in average person's life?. Treasury buying the bad assets through tagging a price will help companies. While getting their books to some decent shape could have helped corporates goto 2001 level, the consumers are still stuck. With this, how can one expect a consumer based economy to change things unless some design has changed radically ?

From a global perspective, this is artificial inflation of the assets through additional pumping of fresh US dollars ( Thanks to non-public disclosure to M3 supply). This just means that dollar will go down in the long term and China and other Gulf nations get more opportunity to stack $700 billion more to their reserves. It will be interesting to see how the emerging markets behave for the next 4-5 months and their GDP levels with a distressed US. This will validate how the US's cold makes the the rest of the world to sneeze.

From a global perspective, this is artificial inflation of the assets through additional pumping of fresh US dollars ( Thanks to non-public disclosure to M3 supply). This just means that dollar will go down in the long term and China and other Gulf nations get more opportunity to stack $700 billion more to their reserves. It will be interesting to see how the emerging markets behave for the next 4-5 months and their GDP levels with a distressed US. This will validate how the US's cold makes the the rest of the world to sneeze.

## Tuesday, September 23, 2008

### Wall Street Turmoil and US Congress response

I planned to take a minute to recap on some of the recent happenings on the current Financial crisis hitting Wallstreet that is ubiquitous on internet, radio, TV and street talks.

To provide some background on why we are where we are :

The creative financial instruments invented by the Wall Street heads in terms of derivatives like MBS, ABS, CDO, CDS etc have started to expose their real face as the interest bearing debts collateralized by these assets don't meet the investment expectations. In simple words, as people holding mortgages can't make their payments on time or get into foreclosures, these derivatives which expect their returns through their payments take a direct hit. This leads to banks not able to pass through their payments to the investors who had bought those derivatives from the bank. In addition, those investors who have insured these risks through insurance companies have passed on these effects to those Insurance companies as well. The creative financial instruments masked the mortgages with low ratings through packaging in different facets thereby giving them an artificial uplift.

Where are we now:

As investors sense a risk to their expected returns due to missing mortgage payments, the confidence level in the underlying assets ( All the securitized derivatives mentioned above) goes down, thereby shorting them. With no cushion build up to resist this fall, this gets into a spiral downward movement. Aaha, the credit ratings , who is supposed to be leading the curve, now wake up and short their ratings on these companies as well paving way for the perfect storm. The companies who didnot see this coming but are burdened with these poor assets are at the brink of filing bankruptcy or closing their business. The trillions of dollars and the big institutions involved in this has the potential to crack the US Financial system which is the rockbed for the jaggernaut capitalistic system. Hence the government intervention to ponder a $700 billion bailout.

Root cause of these issues from my point of view:

1) The rate of these instruments/derivatives coming up were too fast for the credit rating agencies to keep up that ended up endorsing these.

2) The SEC and Govt regulations were not keeping up with these as well.

3) The institutions impacted by this turmoil were too busy finding new customers than take a second look at their risk management models. In addition, their models relied on the credit agencies' ratings.

4) People were either greedy or scared of the skyrocketing home appreciation that everyone wanted to be part of the crowd than taking time to calculate if they can meet their financial obligations.

To provide some background on why we are where we are :

The creative financial instruments invented by the Wall Street heads in terms of derivatives like MBS, ABS, CDO, CDS etc have started to expose their real face as the interest bearing debts collateralized by these assets don't meet the investment expectations. In simple words, as people holding mortgages can't make their payments on time or get into foreclosures, these derivatives which expect their returns through their payments take a direct hit. This leads to banks not able to pass through their payments to the investors who had bought those derivatives from the bank. In addition, those investors who have insured these risks through insurance companies have passed on these effects to those Insurance companies as well. The creative financial instruments masked the mortgages with low ratings through packaging in different facets thereby giving them an artificial uplift.

Where are we now:

As investors sense a risk to their expected returns due to missing mortgage payments, the confidence level in the underlying assets ( All the securitized derivatives mentioned above) goes down, thereby shorting them. With no cushion build up to resist this fall, this gets into a spiral downward movement. Aaha, the credit ratings , who is supposed to be leading the curve, now wake up and short their ratings on these companies as well paving way for the perfect storm. The companies who didnot see this coming but are burdened with these poor assets are at the brink of filing bankruptcy or closing their business. The trillions of dollars and the big institutions involved in this has the potential to crack the US Financial system which is the rockbed for the jaggernaut capitalistic system. Hence the government intervention to ponder a $700 billion bailout.

Root cause of these issues from my point of view:

1) The rate of these instruments/derivatives coming up were too fast for the credit rating agencies to keep up that ended up endorsing these.

2) The SEC and Govt regulations were not keeping up with these as well.

3) The institutions impacted by this turmoil were too busy finding new customers than take a second look at their risk management models. In addition, their models relied on the credit agencies' ratings.

4) People were either greedy or scared of the skyrocketing home appreciation that everyone wanted to be part of the crowd than taking time to calculate if they can meet their financial obligations.

## Sunday, August 10, 2008

### Good Youtube links

Over the years, I have learned that learning through Videos and Podcasts can be efficient and effective. The following is a good place to learn more on financial concepts and in depth security related subject. I plan to add more such Video links both for my reference as well as to save time for people like me. If you have more such links, please share them through comments.

http://www.youtube.com/user/bionicturtledotcom

Goto google and do a search for the following

Structured Finance, Lecture 1 - The Alphabet Soup of the Credit Crisis - 62 min - Jan 30, 2008

Above is from Krassimir Petrov, AUBG - http://home.aubg.bg/faculty/kpetrov/

http://www.youtube.com/user/bionicturtledotcom

Goto google and do a search for the following

Structured Finance, Lecture 1 - The Alphabet Soup of the Credit Crisis - 62 min - Jan 30, 2008

Above is from Krassimir Petrov, AUBG - http://home.aubg.bg/faculty/kpetrov/

## Monday, July 28, 2008

### GDP translated to private spending and govt spending

Rearranging components of GDP, ignoring net exports, one can write the formula as

Investment = GDP - Consumption - Govt spending

In addition,

Savings = GDP - Consumption - Govt spending

= (GDP - T - Consumption) + (T - Govt Spending)

= Private saving + Govt surplus.

Investment = GDP - Consumption - Govt spending

In addition,

Savings = GDP - Consumption - Govt spending

= (GDP - T - Consumption) + (T - Govt Spending)

= Private saving + Govt surplus.

## Sunday, July 27, 2008

### Std deviation vs Beta

The difference between Standard deviation vs Beta of a stock can be understood by starting asking few basic questions.

Let us say you have 2 choices, one to pick investment A and other B.

A is positioned such a way that the expected return, which is the probability of different expected returns due to various factors, is calculated as

E(A) = p(x) * E(x) + p(y) * E(y) + p(z) * E(z)

Note that sum of the above probabilities is 1.

A similar calculation can be done for E(B).

Any average person would pick either A or B, whichever is higher. An educated investor would like to find the risk he/she is taking.

Risk can be measured by calculating standard deviation. Mathematically, std dev is the square root of variance. If an investment's return varies like a roller-coster to provide the return calculated above, it more sounds like a gamble. On the other hand, if the investment has a smaller variance, it is a relatively stable investment where one can lay back and not worry too much on the odds.

How to calculate Std Dev/Risk?

Std dev = sqrt(Variance)

where

Variance = (p(x) * (E(x) - E(A))^2) + (p(y) * (E(y) - E(A))^2) + ( p(z) * (E(z) - E(A))^2

Okay, now that we have a better sense of what the risk is and what the corresponding return is, it makes life easy since the investment with higher return and lower risk wins. No Brainer !!

Let us assume that the return and risk for Investment A than those of B. Now it is logical that A being risky will yield higher return, but is that the best that one can choose. Since we have been comparing oranges and apples, its time to calculate risk for an unit of return. This is called Coefficient of variance.

Calculation is simple .. Just divide Std Dev (A) / E(A). Lets call it C(A).

The investor would pick C(A) or C(B), whichever is lower since the risk to earn an unit of return needs to be lower.

With the above detailed explanation of the basics, one should recall the standard deviation as the risk of a particular investment.

Shifting gears to Beta.

Beta of a stock/investment is the risk of the stock relative to its market risk. While standard deviation measures the standalone risk, Beta measures the relative risk to the market. Eg: Std dev of investment A could be lower than std Dev of B, however B's Beta could be better. To understand this better, let us explore the Beta concept further.

If the entire market in which you trade stock consist of only 1 stock. Then the Beta of the stock will be same as the market risk, meaning when the stock return is of the same proportion and direction as the market return. In contrast, let us assume you have 5 stocks forming a market. When the market return goes up, let us say one of the stock goes down, then the stock is negatively correlated with the market.

Ideally if you have an equal weightage of all stocks forming the market, the unsystematic or stock risk can be nullified. The systematic risk, which is the market risk due to economy and non-company related factors affecting returns cannot be controlled by diversification or effective asset allocation of investments within a portfolio.

Let us say you have 2 choices, one to pick investment A and other B.

A is positioned such a way that the expected return, which is the probability of different expected returns due to various factors, is calculated as

E(A) = p(x) * E(x) + p(y) * E(y) + p(z) * E(z)

Note that sum of the above probabilities is 1.

A similar calculation can be done for E(B).

Any average person would pick either A or B, whichever is higher. An educated investor would like to find the risk he/she is taking.

Risk can be measured by calculating standard deviation. Mathematically, std dev is the square root of variance. If an investment's return varies like a roller-coster to provide the return calculated above, it more sounds like a gamble. On the other hand, if the investment has a smaller variance, it is a relatively stable investment where one can lay back and not worry too much on the odds.

How to calculate Std Dev/Risk?

Std dev = sqrt(Variance)

where

Variance = (p(x) * (E(x) - E(A))^2) + (p(y) * (E(y) - E(A))^2) + ( p(z) * (E(z) - E(A))^2

Okay, now that we have a better sense of what the risk is and what the corresponding return is, it makes life easy since the investment with higher return and lower risk wins. No Brainer !!

Let us assume that the return and risk for Investment A than those of B. Now it is logical that A being risky will yield higher return, but is that the best that one can choose. Since we have been comparing oranges and apples, its time to calculate risk for an unit of return. This is called Coefficient of variance.

Calculation is simple .. Just divide Std Dev (A) / E(A). Lets call it C(A).

The investor would pick C(A) or C(B), whichever is lower since the risk to earn an unit of return needs to be lower.

With the above detailed explanation of the basics, one should recall the standard deviation as the risk of a particular investment.

Shifting gears to Beta.

Beta of a stock/investment is the risk of the stock relative to its market risk. While standard deviation measures the standalone risk, Beta measures the relative risk to the market. Eg: Std dev of investment A could be lower than std Dev of B, however B's Beta could be better. To understand this better, let us explore the Beta concept further.

If the entire market in which you trade stock consist of only 1 stock. Then the Beta of the stock will be same as the market risk, meaning when the stock return is of the same proportion and direction as the market return. In contrast, let us assume you have 5 stocks forming a market. When the market return goes up, let us say one of the stock goes down, then the stock is negatively correlated with the market.

Ideally if you have an equal weightage of all stocks forming the market, the unsystematic or stock risk can be nullified. The systematic risk, which is the market risk due to economy and non-company related factors affecting returns cannot be controlled by diversification or effective asset allocation of investments within a portfolio.

## Monday, February 18, 2008

### CFA - Quantitative analysis.

Let me start by saying time value of money. A $ today is not worth the same $ tomorrow. Hence someone not spending that $ today invests in something that can bring a reasonable additional return tomorrow. The more the risk in investing the more expected, though not guaranteed, return.

This forms the fundamentals of the Quant section leading to Present value (PV) and Future value FV) of money.

-------------------------------

Few formula to calculate future value

FV = PV (1+i)^n

where

FV = Future value

PV = PResent value

i = Expected interest rate or RAte of return

n = Time period

On a basic level, the principal or initial amount is compounded by the interest received at the end of every time period.

eg: $1000 today at 10% interest rate for 5 years compounded annually will be

FV = 1000 * (1+ 0.1)^5

However if the above was compounded semi annually, it would be

FV = 1000 * ( 1 + 0.05) ^ 10

As the frequency of compounding increases, the net FV increases. If the amount is compounded continuously, the equation would become

FV = PV * (e) ^ nr

= PV * (e) ^ (0.1 * 5)

Though knowing the above concepts is good, from a CFA point of view, it is more important that one knows how to use the financial calculator. The key is to identify and make sure that the n values and r values to be input are correct based on the frequency of compounding. A lot of practice is needed so as to not go wrong in this simple area.

--------

Annuity in simple terms mean a series of periodic payments. Unlike PV where the entire principal is a one time lump sum, Annuity is same amounts applied in equal time periods. Hence common sense is that, with all factors being equal, FV for sum of annuity amounts will be lower than the FV for the same amount when invested as a lump sum today.

Annuity normal or regular is when the payments are invested or applied at the end of every time period whereas Annuity due is when the payments are invested or applied at the begining of the time period. Use Begin mode to calculate PV or FV for Annuity due and End mode for ordinary annuity. A special case of Annuity is perpetuity where PV is CF/discount rate. Perpetuity in layman terms mean that the periodic payments run till end of one's life period.

------------

Another area to focus is the chance of something happening. Typically in financial world, this is applied to the chance or probability that a particular asset/security/portfolio will result in a particular return for a given risk.

The Expected return for a security is given by the sum of (probability of something happening* expected return if that happens)

Eg:

If consumer sentiment optimistic, expected return for a particular stock is $1.25 per share

Let us say that the probability of that happening is 80%.

If consumer sentiment optimistic, expected return for a particular stock is $0.25 per share

Let us say that the probability of that happening is 20%.

From the above, if someone invests in the above stock, the expected return would be the weighted average, ie (0.8 * 1.25) + ( 0.2 * 0.25) = 1.05

Assuming there is another stock with the same return, but a different combination of probabilities and return attributes, then one needs to weigh in the risk of putting the money in one vs another. This is calculated through the Standard deviation, which is square root of variance.

In our example,

variance = (1.25-1.05)^2 * 0.8 + (0.25-1.05)^2 * 0.2

= .04*0.8 + (.64 * .2)

= .032 + .124

= .156

SD = sqrt(var) = .39

Hence the expected return can vary from .75 to 1.44 (Exp return +_ SD)

If we did a similar calculation for a different stock and end up with a range 1 to 1.1, then we know that the risk of the other stock is less since the expected returns oscillate in a narrow range.

The above analysis works fine if the expected returns are same but SD's are different. What if a stock with higher Expected return has more SD compared to another with lower return but a lower risk. To make apple to apple comparison, we calculate Coefficient of variation which is defined as risk per unit of return

Hence CV = Return/SD.

------------------

When someone tells you that they can earn you $5 dollars in 1 yr for every $ you invest, how can you weigh in on their claim. Well, hypothesis testing comes to the rescue. All you need is a sample of their performance that contains the number of sample, mean return of the sample and the SD of the sample. Using the above data, one can tell with a certain % of confidence that their claim is valid or not valid.

Formula:

CI = Mean(sample) +- t value * std error

If sample size small, t value need to be used. Note that degree of freedom should be used to look up t value. df = sample size - 1

std error = SD of sample/ sqrt(sample size)

This is a two tailed model since the Null hypothesis where claim = $5 needs to be rejected or not rejected and the alternative hypothesis is everything but that.

There may be cases when the claim could be >= $5 in which case, the analysis would be one-tailed analysis.

( All the above notes have been without looking at any notes. I will take additional time tomorrow to provide better examples and also revisit the sequence for better readability).

Done for the day :)

This forms the fundamentals of the Quant section leading to Present value (PV) and Future value FV) of money.

**Present Value and Future value:**-------------------------------

Few formula to calculate future value

FV = PV (1+i)^n

where

FV = Future value

PV = PResent value

i = Expected interest rate or RAte of return

n = Time period

On a basic level, the principal or initial amount is compounded by the interest received at the end of every time period.

eg: $1000 today at 10% interest rate for 5 years compounded annually will be

FV = 1000 * (1+ 0.1)^5

However if the above was compounded semi annually, it would be

FV = 1000 * ( 1 + 0.05) ^ 10

As the frequency of compounding increases, the net FV increases. If the amount is compounded continuously, the equation would become

FV = PV * (e) ^ nr

= PV * (e) ^ (0.1 * 5)

Though knowing the above concepts is good, from a CFA point of view, it is more important that one knows how to use the financial calculator. The key is to identify and make sure that the n values and r values to be input are correct based on the frequency of compounding. A lot of practice is needed so as to not go wrong in this simple area.

**Annuity:**--------

Annuity in simple terms mean a series of periodic payments. Unlike PV where the entire principal is a one time lump sum, Annuity is same amounts applied in equal time periods. Hence common sense is that, with all factors being equal, FV for sum of annuity amounts will be lower than the FV for the same amount when invested as a lump sum today.

Annuity normal or regular is when the payments are invested or applied at the end of every time period whereas Annuity due is when the payments are invested or applied at the begining of the time period. Use Begin mode to calculate PV or FV for Annuity due and End mode for ordinary annuity. A special case of Annuity is perpetuity where PV is CF/discount rate. Perpetuity in layman terms mean that the periodic payments run till end of one's life period.

**Probability:**------------

Another area to focus is the chance of something happening. Typically in financial world, this is applied to the chance or probability that a particular asset/security/portfolio will result in a particular return for a given risk.

The Expected return for a security is given by the sum of (probability of something happening* expected return if that happens)

Eg:

If consumer sentiment optimistic, expected return for a particular stock is $1.25 per share

Let us say that the probability of that happening is 80%.

If consumer sentiment optimistic, expected return for a particular stock is $0.25 per share

Let us say that the probability of that happening is 20%.

From the above, if someone invests in the above stock, the expected return would be the weighted average, ie (0.8 * 1.25) + ( 0.2 * 0.25) = 1.05

Assuming there is another stock with the same return, but a different combination of probabilities and return attributes, then one needs to weigh in the risk of putting the money in one vs another. This is calculated through the Standard deviation, which is square root of variance.

In our example,

variance = (1.25-1.05)^2 * 0.8 + (0.25-1.05)^2 * 0.2

= .04*0.8 + (.64 * .2)

= .032 + .124

= .156

SD = sqrt(var) = .39

Hence the expected return can vary from .75 to 1.44 (Exp return +_ SD)

If we did a similar calculation for a different stock and end up with a range 1 to 1.1, then we know that the risk of the other stock is less since the expected returns oscillate in a narrow range.

The above analysis works fine if the expected returns are same but SD's are different. What if a stock with higher Expected return has more SD compared to another with lower return but a lower risk. To make apple to apple comparison, we calculate Coefficient of variation which is defined as risk per unit of return

Hence CV = Return/SD.

**Hypothesis testing**:------------------

When someone tells you that they can earn you $5 dollars in 1 yr for every $ you invest, how can you weigh in on their claim. Well, hypothesis testing comes to the rescue. All you need is a sample of their performance that contains the number of sample, mean return of the sample and the SD of the sample. Using the above data, one can tell with a certain % of confidence that their claim is valid or not valid.

Formula:

CI = Mean(sample) +- t value * std error

If sample size small, t value need to be used. Note that degree of freedom should be used to look up t value. df = sample size - 1

std error = SD of sample/ sqrt(sample size)

This is a two tailed model since the Null hypothesis where claim = $5 needs to be rejected or not rejected and the alternative hypothesis is everything but that.

There may be cases when the claim could be >= $5 in which case, the analysis would be one-tailed analysis.

( All the above notes have been without looking at any notes. I will take additional time tomorrow to provide better examples and also revisit the sequence for better readability).

Done for the day :)

## Wednesday, January 23, 2008

### Sensex volatility

The last 2 days of heavy selling seen globally, especially in India, has been portrayed as

"India’s investors lack sophistication"

Indian fundamentals are strong in the long run, however, there is still a heavy biding to the US economy. With substantial percentage of Indian GDP still relying on Indian exports, with US dominating that pie, it ultimately means that the Sensex is subjected to volatility in the days ahead until we see US consumer confidence.

From a long term view, within a span of 2 years, the Indian economy will play a dominant role following the output of FDI investments currently at work.

"India’s investors lack sophistication"

**My take on the above:**Indian fundamentals are strong in the long run, however, there is still a heavy biding to the US economy. With substantial percentage of Indian GDP still relying on Indian exports, with US dominating that pie, it ultimately means that the Sensex is subjected to volatility in the days ahead until we see US consumer confidence.

From a long term view, within a span of 2 years, the Indian economy will play a dominant role following the output of FDI investments currently at work.

## Sunday, January 20, 2008

### CFA Links

http://www.analystforum.com/phorums/list.php?11

http://unjobs.org/authors/ashwinpaul-c.-sondhi

http://www.dubravac.us/CFA.html

Learning Outcome Statements (LOS) for CFA Level 1

http://www.cfainstitute.org/cfaprog/resources/l1_outline.html

Standards of Practice Handbook

http://www.cfapubs.org/toc/ccb/2005/2005/3

http://unjobs.org/authors/ashwinpaul-c.-sondhi

http://www.dubravac.us/CFA.html

Learning Outcome Statements (LOS) for CFA Level 1

http://www.cfainstitute.org/cfaprog/resources/l1_outline.html

Standards of Practice Handbook

http://www.cfapubs.org/toc/ccb/2005/2005/3

### A closer look at Sovereign funds

I plan to do some analysis based on data from site below. More to come...

http://biz.yahoo.com/ap/080115/sovereign_wealth_funds_glance.html?.v=1

http://biz.yahoo.com/ap/080115/sovereign_wealth_funds_glance.html?.v=1

## Wednesday, January 9, 2008

### CFA Level 1 Exam Prep Self Notes.

I finally made up my mind to take the CFA Level 1 Exam. Have been reading few materials and gathering info from various sites. I planned to take few minutes and consolidate my learnings till date. I expect this writing to be both useful for me to recap frequently as well as quick reads for other aspirants. I also admit that my writing skills might not be best presented, however, I have focussed more on the meat and tried to put it in a way easy to digest for me. For someone who is already preparing for the exam or someone with financial fundamentals, the reading should be reasonably okay.

I would love to take any of your questions and similarly participate in your forums . Just let me know your blog/website. Good luck folks and happy reading !! :)

Financial Statements:

--------------------

The 4 basic financial statements (BS, PL, RE, CF) is usually accompanied by the following.

Footnotes - Audited.

Management Discussion & Analysis - Not Audited.

Supplementary schedules - Not Audited.

Proxy statements - ?

Audit opinions can fit into any of the following categories.

1) Qualified - Something's fishy..pls take it with caution

2) Non-qualified - Looks good and clean, though maynot be error free.

3) Adverse - Sorry, statements don't meet standards.

4) - Didn't find anything wrong, however,I would like to do more before giving a thumbs up, but for some reason, I couldnot do it.

Operating lease vs capital lease effect on financial statements:

----------------------------------------------------------------

Leasing Inventories, equipments etc is common. However, how they are shown on balance sheets can differ.

If leased assets are planned to be used for greater than 75% of their normal life time, they ought to be considered as Capital lease.

If NPV of payments made for the leased asset > 90% of its normal value, they fit capital lease.

If ownership could either be transferred or a bargain can be made at the end of the lease, they fit capital lease.

Pros and Cons:

P&L impact:

Under capital lease, the depreciation can be expensed at the cost of Net income. ( Though subjected to the method of depriciation adopted)

Under capital lease, the interest paid to the fund borrowed for paying the lease can considered as expense and hence tax deducted.

Under operating lease, net income can increase during the earlier phase of leasing as opposed to capital since there is no depreciation expense in the equation.

Cash Flow impact:

Under capital lease, depreciation boosts the cash flow. ( after tax effect).

Under operating lease, the payment paid towards the lease is considered as operating expense thereby lowering the operating cash flow.

Interrelation between Balance sheet, P&L, Cash flow and RE statement :

--------------------------------------------------------------------

Change in Cash account on balance sheet same as change in operating cash flow ( cash reduction due to increase in assets/inventories, reduction in accounts payable, reduction in other current liabilities and cash increase due to sale of assets/inventories, decrease in AR etc)

Net income from P&L same as begining balance in Cash flow using indirect method.

Cost of capital and rationale behind equity vs debt financiing:

-------------------------------------------------------------

Company gets money to run business either through equities (Stocks,bonds) or debt( loans etc). Creditors expect return for lending this money to the firms.

Hence there is a cost to the capital. If company runs with 60% stock money and 40% debt money and lets say equity creditors expect 10% return and debt loaners expect 5% then ..assuming corporate tax is 30%.

WACC = (0.6 * 10) + (0.4 * (0.5 (1-0.3)))

Within equities, returns expected by stock holders are > bond holders since company has the flexibility of either paying or not paying stock dividends. In case of bonds, company is obligated to pay the promised coupon rate. If companies know for sure that they will definetly grow well and if their current market stock price is undervalued, then they are better off to go for loans/bonds. If company's stocks are overpriced, then the cost of capital, which has an inverse component on the stock price, becomes a cheap deal and hence can get more bang for the buck ( overall cost including floatation cost).

If a company is too small and has high aspirations, however, the banks/loaners maynot have the company's proven credit history, and hence the company might turn towards equity.Another situation for equity would be that the company's returns are sure but not immediate enough to generate cash flows for meeting the loan payment obligations.

Firm/Equity valuation:

-----------------------

If a company expects a constant growth and if the growth rate is lower than the expected rate of return, then the value of the stock can be determined through Gordon Growth Model (GGM).

V = D(1+g)

------

r - g

D - Current dividend

Eg: If a company pays a dollar per share and expects a constant growth of 5% ,and the expected investor return is 10%, then one should buy the stock today for

v = 1(1+0.05) 1.05/0.05 = 105/5 = $21

------- =

0.1 - 0.05

If at the end of next year, the company prospects turn really good and hence lets say that the company revises its growth rate to 9%, then the stock price will be

v = 1.05* ( 1+0.09)/0.01 = 1.1445/0.01 = $114.45

On the other hand, had the company revised the growth to 2%, then the stock value would have been

v = 1.05*(1.02)/0.08 = 1.071/0.08 = 107.1/8 = $13.38

If the company's growth rate is > expected return ( GooG can be a good example), then GGM cannot be applied. Rather the discounted cash flow method need to be used. Let us say investors expect growth rate 10%, but company expects 20%, then stock price would be

V = Dividend year1/(1+0.1) + Dividend year 2 /((1+0.1)*(1+0.1)) + .....

More to come on this at a later point...........

I would love to take any of your questions and similarly participate in your forums . Just let me know your blog/website. Good luck folks and happy reading !! :)

Financial Statements:

--------------------

The 4 basic financial statements (BS, PL, RE, CF) is usually accompanied by the following.

Footnotes - Audited.

Management Discussion & Analysis - Not Audited.

Supplementary schedules - Not Audited.

Proxy statements - ?

Audit opinions can fit into any of the following categories.

1) Qualified - Something's fishy..pls take it with caution

2) Non-qualified - Looks good and clean, though maynot be error free.

3) Adverse - Sorry, statements don't meet standards.

4) - Didn't find anything wrong, however,I would like to do more before giving a thumbs up, but for some reason, I couldnot do it.

Operating lease vs capital lease effect on financial statements:

----------------------------------------------------------------

Leasing Inventories, equipments etc is common. However, how they are shown on balance sheets can differ.

If leased assets are planned to be used for greater than 75% of their normal life time, they ought to be considered as Capital lease.

If NPV of payments made for the leased asset > 90% of its normal value, they fit capital lease.

If ownership could either be transferred or a bargain can be made at the end of the lease, they fit capital lease.

Pros and Cons:

P&L impact:

Under capital lease, the depreciation can be expensed at the cost of Net income. ( Though subjected to the method of depriciation adopted)

Under capital lease, the interest paid to the fund borrowed for paying the lease can considered as expense and hence tax deducted.

Under operating lease, net income can increase during the earlier phase of leasing as opposed to capital since there is no depreciation expense in the equation.

Cash Flow impact:

Under capital lease, depreciation boosts the cash flow. ( after tax effect).

Under operating lease, the payment paid towards the lease is considered as operating expense thereby lowering the operating cash flow.

Interrelation between Balance sheet, P&L, Cash flow and RE statement :

--------------------------------------------------------------------

Change in Cash account on balance sheet same as change in operating cash flow ( cash reduction due to increase in assets/inventories, reduction in accounts payable, reduction in other current liabilities and cash increase due to sale of assets/inventories, decrease in AR etc)

Net income from P&L same as begining balance in Cash flow using indirect method.

Cost of capital and rationale behind equity vs debt financiing:

-------------------------------------------------------------

Company gets money to run business either through equities (Stocks,bonds) or debt( loans etc). Creditors expect return for lending this money to the firms.

Hence there is a cost to the capital. If company runs with 60% stock money and 40% debt money and lets say equity creditors expect 10% return and debt loaners expect 5% then ..assuming corporate tax is 30%.

WACC = (0.6 * 10) + (0.4 * (0.5 (1-0.3)))

Within equities, returns expected by stock holders are > bond holders since company has the flexibility of either paying or not paying stock dividends. In case of bonds, company is obligated to pay the promised coupon rate. If companies know for sure that they will definetly grow well and if their current market stock price is undervalued, then they are better off to go for loans/bonds. If company's stocks are overpriced, then the cost of capital, which has an inverse component on the stock price, becomes a cheap deal and hence can get more bang for the buck ( overall cost including floatation cost).

If a company is too small and has high aspirations, however, the banks/loaners maynot have the company's proven credit history, and hence the company might turn towards equity.Another situation for equity would be that the company's returns are sure but not immediate enough to generate cash flows for meeting the loan payment obligations.

Firm/Equity valuation:

-----------------------

If a company expects a constant growth and if the growth rate is lower than the expected rate of return, then the value of the stock can be determined through Gordon Growth Model (GGM).

V = D(1+g)

------

r - g

D - Current dividend

Eg: If a company pays a dollar per share and expects a constant growth of 5% ,and the expected investor return is 10%, then one should buy the stock today for

v = 1(1+0.05) 1.05/0.05 = 105/5 = $21

------- =

0.1 - 0.05

If at the end of next year, the company prospects turn really good and hence lets say that the company revises its growth rate to 9%, then the stock price will be

v = 1.05* ( 1+0.09)/0.01 = 1.1445/0.01 = $114.45

On the other hand, had the company revised the growth to 2%, then the stock value would have been

v = 1.05*(1.02)/0.08 = 1.071/0.08 = 107.1/8 = $13.38

If the company's growth rate is > expected return ( GooG can be a good example), then GGM cannot be applied. Rather the discounted cash flow method need to be used. Let us say investors expect growth rate 10%, but company expects 20%, then stock price would be

V = Dividend year1/(1+0.1) + Dividend year 2 /((1+0.1)*(1+0.1)) + .....

More to come on this at a later point...........

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