1 Equity Valuation 2009 CFA Level II Simon Mei CFA

2 Free Cash Flow Valuation Vol I, Exam 1, Q19-24 FCFF=NI + NCC+[Int x (1-tax rate)] - FCInv – WCInv FCFE=NI + NCC – FCInv – WCInv + net borrowing WCInv excluding cash and equivalents, notes payable and current portion of long-term debt If new notes payable issued: FCFE: net borrowing will increase equal to notes payable FCFF: Notes payable should adjusted WACC as short term debt FCFF: Other liabilities may appear after Long-term debt, Int * (1-t) should include Long-term debt interest and Other Interest

3 Free Cash Flow Valuation Free cash flow with preferred stock Treat preferred stock like debt, but not tax deductible Any preferred dividends should be added back to FCFF, assuming Net Income is after Preferred dividend (while the traditional Net Income is before Preferred dividend, pay attention to the definition) WACC should be adjusted to reflect the % of capital raised by preferred stocks and the costs

4 Normalized Earning Vol I, Exam 1, Q25-30 Unusual expenses should be adjusted from reported earning to normalized earning, Unusual items are deducted before tax In most cases, the adjustment is Reported earning + unusual expenses * (1- t) If income tax accounting makes things complicated, we can start from Earning before tax, then multiple (1-t)

5 Carried Interests Vol I, Exam 1, Q61-66, Vol II, Exam 1, Q There are 3 methods to calculate the carried interests: deal by deal, total return method 1, total method 2 In most cases, Total return method 1 means carried interest is calculated if fund value exceeds committed capital; After that, carried interest is equal to e.g. (NAV before distribution 2008 – NAV before distribution 2007) * 20% Total return method 2 means carried interest is calculated if fund value exceeds invested capital; it may also require the minimum hurdle rate, e.g. (180 – 120*(1+10%))*20%

6 CAPM vs FFM Vol I, Exam 1, Q91-96, Exam 2, Q73-78 CAPM: required return on stock j = current risk-free return + (equity risk premium) × (beta of j) FFM: required return of stock j = RF + βmkt,j × market risk premium + βSMB,j × small-cap risk premium + βHML,j × value risk premium βSMB, βHML could be negative, the return from FFM could be higher or lower than the return from CAPM The more factors input, the more uncertainty of the model, thus FFM has greater input uncertainty than CAPM.

7 RI single stage model & P/B Ratio Vol I, Exam 2, Q19-24 If ROE > r, the discount value of RI is positive, P/B >1 If ROE = r, the discount value of RI is zero, P/B =1 If ROE < r, the discount value of RI is negative, P/B <1 Also, it is possible to solve the implied growth rate g

8 Amortization Loan vs Interest Only Loan Vol I, Exam 3, Q31-36, Vol II, Exam 2, Q43-48 In textbook, we use amortization loan to calculate CFAT and ERAT; In the exam, interest only loan is applied Amort LoanInterest Only Loan CFAT: InterestInterest portion from equal monthly payment Principal times interest rate CFAT: Debt serviceEqual monthly payment * n (Annual debt service, PMT) Principal times interest rate ERAT mortgage balTotal payment minus interets Original Loan amount

9 Sustainable Growth Rate Vol II, Exam 3, Q31-36 SGR has two implied assumptions: Firm’s debt-to equity ratio remains constant Doesn’t issue new equity Implication: the firm will retain some earning and issue new debt keeping the debt-to-equity ratio constant

10 The End Relax & Good Luck in the Exams !!! Please contact me at