How RI = (ROE - r) x B0?

It is a simple derivation.

RI1 = NI1- rB0

ROE = NI/B0

NI = ROE x B0

RI1 = ROExB0 - rB0

RI1 = B0 (ROE - r)

Re-arranging

RI1 = (ROE - r) B0

Test - Equity Investment

Aiming something along with identifying a time frame to complete that objective is way more productive than aiming on stand alone basis. Last week I was done with Equity Investments. I had to appear in a test comprising whole equity portion today, 11th March. As I had a target defined, I planned and organized my studies and was able to revise all the readings in one week. Today I appeared in the test and I was able to score 75% marks. Although my aim was to correct on average 5 MCQs in a Vignette, which I did achieve but only 1 item set in which due to lack of stamina, I got 5 of the answers wrong! It ruined my average. Still the result is encouraging as 95% of my calculation part is correct. As I'm feeling comfortable with the calculation part, the theory part especially Porter's 5 forces, Industrial Analysis and other relations discussed in Multiples and Private equity valuation, can now be focused by me while doing revision. As you all know that Equity and FRA are major areas of Level II. Once I'm done with the syllabus, I need to revise these areas almost on daily basis so that I could retain the concepts. Calculations can only be mastered through practice and based upon today's performance I'm experiencing myself one step ahead in my preparation specifically considering the calculation part. I believe you should also plan your tests to learn critical concepts through practice. For instance today I learned that cost of equity and required rate of return if are not equal then while calculating PVGO we'll use required rate of return not cost of equity. In this way learning through practice and making yourself comfortable with calculation part is very important which can be done through tests. This was my experience. In my last test of equity I had secured 60% marks and today I have crossed 70. It will motivate me further and help me overcome the burnout which I've started to experience to some extent. These months hold immense importance and we need to make them productive! Good luck.

FCFE - Corning Incorporated

Components	Dec-11	Dec-10
CFO	3,189,000	3,835,000
Change in Other Assets	43,000	24,000
Change in PPoE	1,728,000	948,000
Change in Intangible Assets	210,000	40,000
FCInv	1,981,000	1,012,000
Change in Short Term Debt	(30,000)	(17,000)
Change in Long Terb Debt	102,000	332,000
Net Borrowings	72,000	315,000
FCFE	1,280,000	3,138,000

Residual Income - An important point to ponder

The formula is pretty straight forward:

RI(t) = E(t) - rB(t-1)

RI(t) = Residual Income at t
E(t) = Earnings at t
r = required rate of return on equity
B(t-1) = Ending Book value at t-1 or Beginning book value at t

The Earning is expected for the next year but the book value is current. This is an important point but I don't know why I was skipping it continuously. While calculating the residual income for several years I was also projecting the book value but I repeated this mistake multiple times that the book value I took to calculate RI was ending not the beginning at time t which made several of my questions wrong. In few questions an option was also there which reflected the number calculated using ending book value at time t. It implies that the question designer had this thing in mind that the candidates can make this mistake. This is an important point which I learned, thought to share it with you guys. 

News Pick - Windows 8 launch will boost Windows Phone sales says Microsoft

Investors respond to developments regarding companies and based upon that they make decisions of buying and selling to generate returns. How investors behaviour respond to such news is a different area but anticipating the performance of companies through their decisions reflect in their market prices. Analysts incorporate such factors in giving recommendations about stocks. Equity valuation is an important area of CFA Level I and Level II curriculum. DCF models evaluate the present value of future cash flows and based upon that value the stock. Regarding future cash flows developments taking currently matter a lot. Microsoft has launched the beta version of Windows 8. Windows have been a strong product of Microsoft in terms of revenue generation. The following article highlights the viewpoint of Microsoft. Will it result in increasing the market value of Microsoft?

Read the article: http://www.theinquirer.net/inquirer/news/2156184/windows-launch-boost-windows-phone-sales-microsoft

Solving FCFE Questions - A technical point to ponder

FCFE from NI is calculated as follows

FCFE = NI + NCC + Net Borrowings - WCInv - FCInv

As you can see in the above formula there is no link of tax as Interest rate net of tax is added back to the FCFF but while calculating FCFE it is not included as FCFE are free cash flows available to equity investors. I encountered a question in which it was stated that the tax rate of investor is 35% and for me it was strange, I immediately thought that FCFE has nothing to do with tax so the question contains a trick. I solved it and to my surprise the answer was wrong. Later on reviewing the question I came to know that if the question states to use a different tax rate then in spite of starting from NI we should use Profit before tax (EBT) and then tax it to arrive at NI in order to calculate the FCFE. Later I thought it made sense but while I was solving the question I ignored this point and concluded incorrectly.

Moreover the WCInv and FCInv are two numbers which mostly require lengthy calculation as compared to the other values in calculating FCFE or FCFF. After solving a lot of questions I have concluded that when the question asks about calculating FCFE or FCFF then the first calculation should be done of WCInv and FCInv as other numbers are pretty straight forward and can be plugged into the calculator but these two, since require some calculations, if gathered early then arriving at FCFE and FCFF becomes easy.

I hope these will help you out. Equity is not only an area with high weight-age but it is also a high scoring area. I think ample practice can help in getting above 70 in this area and impacting the overall result positively. 

Remembering the Formulae.

In Level I, I used to re-read the material in order to remember the formulas. Used mnemonics in case of Ethics and other areas so that I could remember important key terms and other relations. This thing is not working that well in Level II probably due to immensely excessive material as compared to Level I. I heard some one saying that he used to remember the formulas by taking a snapshot of them in his mind and then recalling that picture again and again to not forget. I have tried this and it has helped me a bit but the thing which I did only once was reading, remembering and re-writing the formulae again and again to make myself comfortable with them, which proved productive. For Free Cash Flow valuations and arriving at FCFF or FCFE starting from NI, EBIDTA, EBIT, or CFO, plenty of formulae are involved which need to be remembered. I am going to try remembering them all through re-writing them. I hope it will be productive. You should also try this....

Problem Solving vs Auditing - An important aspect which can add value.

There is considerable difference between solving the problems and auditing them. Usually when I am looking at the examples of curriculum, after reading the statement I immediately look at the solution to check the answer and pamper myself that how simple and logical is the answer, obviously this is the way it should be done. Does that really serve my cause? The answer is clearly NO. I don't know what exactly you guys would be doing but for sure if you are doing Equity, FSA, Corporate Finance, Derivatives or any other areas which require calculations and trickiness, I believe the 'justified' behaviour would be to solve those examples and chapter end questions without referring to the answers immediately. Unless the 'brain machinery' utilizes its self on the problem and figuring out its correct answer, the purpose of learning does not serve! I did this for Derivatives especially in swaps and I am doing this on Reading 39 and 40 (at present) of Equity to make myself comfortable with the concepts. I hope it will help you out. 

Market Watch - Why calm in Europe will boost Apple, Home Depot

Those who are done with Level I or Level II Equity would enjoy reading this article. Since I am going through this topic, the 'pleasing factor' for me is a bit more. A lot of terminologies which we read in the curriculum are used here. This particular exercise which relates the 'real world happenings' to what that I read helps me get familiar with a lot of stuff which after some time sounds normal to me and the jargon become my routine words. I hope you'll be experiencing the same.

Read the article: http://www.marketwatch.com/story/why-calm-in-europe-will-boost-apple-home-depot-2012-02-22?link=MW_latest_news

Nominal risk free rate in local currency (Reading 38 - Valuation in Emerging Markets)

Nominal risk free rate in local currency = [{(1+Risk Free Rate based on 10-yr U.S. Government Bond Yield) x (1+local inflation)] / (1 + U.S. Inflation)}] - 1

Now this was something really confusing for me... I rearranged the formula and got this one

(1+Nominal RFR in Local Currency) / (1+local inflation) = (1+RFR on 10/Y US Govt. bond yield) / (1+US Inflation)

Obviously to calculate the percentage the 1+ thing is used but it is simply 

It implies that we are only taking a ratio of Local Inflation to US Inflation and then using the 10-year YTM on US Government bond and using that inflation ratio to calculate the Risk free rate in local currency. Quite simple to remember now!

Understanding Equity through CFAI Text examples - Level II

Equity is an important area of Level II curriculum with a major chunk in terms of weight-age. Hardly any CFA Charter holder would be 'inefficient' in this area. The material is not complex but there are small technicalities involved. For instance while deducing equity risk premium historical or future which one would be suitable? In calculating Required Return whether long term yield or short term yield on risk free securities is required for calculations etc. I think the examples of this particular area are very helpful in understanding the technicalities involved. Especially examples expressing Fama French Model in Reading 35 is extremely important in understanding the relationship of Beta with Market, Size and Value segregations.

Another technicality involved in assessing the equity risk premium or the required rate of return is the incorporation of appropriate model. For instance certain models cannot be incorporated in emerging markets whereas others can. GGM cannot be used when dividend growth and earning growth cannot be predicted reliably. Macroeconomic models also require some 'pre-requisite' state of the economy to be implemented efficiently.

Mere cramming of the requirements of these models could be a wise strategy for exams perspective but understanding them with adequate diligence can help in making things appear more sensible. I am done with examples of Reading 35 shortly I will be done with the chapter end questions of CFAI Text to evaluate myself. Reasonable practice can ensure that the technicalities have been retained or not.