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:
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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:
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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 :
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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:
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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:
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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)
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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...........