10 Minute Review of CFA Ethics and Standards

Even with the change to topic area weights on the CFA exams this year, CFA Ethics and Professional Standards remain extremely important. It is a lot of material but fortunately doesn’t change much from year to year and you’ve got a real opportunity to carry over some points to each exam if you learn it early.

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CFA Level 2 Exam – How hard ?

The Level II Exam is, in mine and many other candidates, the most difficult level of the three CFA exams and it might be hard to narrow it down to just five things.

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CFA Level 2 – Read questions or vignette first?

The CFA Level 2 exam is considered by most to be the most difficult of the three exams. Whereas the first exam was largely conceptual and tested your basic understanding of a broad range of information, CFA Level 2 exam takes that same broad range but tests detailed concepts and data interpretation. On top of this, the exam is extremely formula intense. You will be responsible for calculating two and three-part formulas in almost every study session.

There are strategies that will get you through all three exams and those that you will need to change for each test. We will cover those strategies and advice specific to CFA Level 2 exam here and hold the broader suggestions for a future post. We will also look at two different schedules in the strategy post that could aid in planning.

CFA Level 2 Format and Basic Strategy:

CFA Level 2 exam consists of 20 item-set questions, each with six separate multiple choice questions that must be answered from information in an approximately one-page vignette. Each item set question will only cover one study session (i.e. ethics, quantitative methods, asset allocation, etc.) which makes it a little easier to concentrate on one topic at a time. As with all levels of the CFA, there are a total of 360 points possible, so each item set is worth five percent of your total points.

CFA Level 2 practice exams

While the CFA Institute does not publish what the passing score is for each year, they have said that no score of 70% or above has ever failed the exam. What does this mean? It means you should be completing practice exams and aiming for a score of at least 75%. Your practice exams may not mimic the actual exam exactly, but shooting for a higher average will give you some breathing room when it comes to test day.

CFA Level 2 Exam Item set question – Read questions or vignette first?

There are two schools of thought when tackling the individual item sets on the level II exam. Many candidates read through the six questions quickly to better understand the information for which they are looking. Other candidates start by reading the vignette, looking for information that may be important. After studying through the curriculum in preparation for the exam, you will begin to get a sense of what information is important for questions.

Remember, you are able to make notes in your exam booklet, so be sure to underline or highlight numerical information or other important points to find them more easily while answering the questions.

CFA Level 2 – Which item-set questions to answer first?

You may want to complete those item sets first in topics in which you are stronger. This will do two things. First, answering a good portion of the questions quickly and strongly will boost your confidence for the harder item sets. Secondly, answering those questions you are more likely to get right will save time and book the easy points before moving on to the less probable points. Just remember to effectively watch your bubble-sheet answer form to make sure you are filling in the correct numbers.

CFA Level 2 Topic Weight Differences on the Exam

Comparing the topic weights for the level II and the level I exam provided by the CFA Institute, there are a couple of things you should note.

  • Ethics is still a good portion of the exam, but not as much so as the level I exam. Your time spent here depends on part by how much you remember from the first exam and how well you did. If you got above 70% on the first exam and can score well on practice tests, then you will not have to study quite as much. Do not neglect the area because you will see it again on the level III exam.
  • CFA level II exam is much more heavily weighted towards asset classes than investment tools. The second exam is an analyst’s exam because you are going to spend a ton of time learning how to analyze the specific assets and investments within each. It is much more quantitatively intensive than the first exam.
  • Equity investments is the single biggest section and should be treated as such in your study schedule. Closely behind this is the Financial Reporting and Analysis section. Hopefully, you spent the time necessary to build a good base of knowledge in the three financial statements on the first exam. If not, you will need to review to be able to do well on FRA.

Ethical and Professional Standards, while not worth as many points as in the first exam is still very important. It is still a guaranteed 10% of your points, and you will see almost the same material at level III. I was able to reduce my time studying on the ethics portion of the level III to just looking over the new material because of my time spent studying for the other two exams.

Corporate Finance and Economics is again fairly conceptual though you will be responsible for some growth and emerging market formulas as well as dividend policy formulas. Summary sheets are often the best way to approach conceptual study sessions because you can outline the ideas and key points. This should get you the majority of points on the exam and free up study time for other areas.

Financial Reporting and Analysis is, with equity, your two ‘core’ topic areas for the level II exam. These two topics are worth between 35-55% of your total exam score. If you picked up a good base of understanding in the three financial statements at the first level, then the second exam is just detailing separate accounts and valuations. The readings here are extremely long and you will need to work through them. Do not expect to pick up the material with reading alone. The material is practice-based and you need to actively work through the examples in the books.

Quantitative Methods is slightly less important in the second exam and more so when you get to the third exam. The material here builds on some of the methods learned in the first exam. Do not neglect the section because you will get at least one item set, maybe two. You should be able to get the majority of the points by understanding the basic procedure in the formulas and any strengths, weaknesses, or biases.

Alternative Investments is slightly more important at the second and third level exams compared to the first, but still of secondary importance overall. The curriculum follows a finite set of ‘alternative’ assets (i.e. real estate, hedge funds, private equity, etc.) and each level builds in little more detail. While there are more calculations required in the second exam, it is still largely conceptual. Again, with conceptual topic areas, use a summary guide to learn the key points, strengths, weaknesses and biases.

Derivatives is also marginally more important on the second exam but extremely more quantitatively intense. You will confront some fairly lengthy pricing formulas here and will see between one and three item sets on the exam. For the formulas, first try to understand the logic behind the calculation to better memorize the formula. Often, working over practice problems is the only way to really convert the material to long-term memory.

Equity Investments is potentially the largest part of the exam with between four to six item sets. This and Financial Reporting & Analysis is where you really need to spend your time and learn the material. Working through practice exams, you should be aiming for at least 75% or higher going into the exam.

Fixed Income is also more quantitatively intense at the second level of the CFA exams. Many candidates are less familiar with debt instruments and do poorly on the topic. Begin with a basic understanding of the topic before you proceed to the detailed formulas. Do not neglect pricing and amortization of debt or some of the other formulas.

Portfolio Management  will set you up for the third exam where it is extremely important. Pay particular attention to the Investor Policy Statement (IPS) because it is pivotal to the third exam. Fortunately, much of the section is conceptually-based so you can get the majority of the points by understanding key points and ideas.

While you cannot afford to neglect any of the study areas in the level II curriculum, there are some on which you can spend more or less time. Ethics, FRA, Equity and Fixed-Income will account for upwards of two-thirds of the exam. If you concentrate your study time in these sections, aiming for a score of 75% or higher, you will have a very good chance of passing the exam.

You have a finite time before the exam so remember to use your study time efficiently. Take advantage of condensed study guides, summary sheets and flash cards to focus on the key concepts and formulas.

Read detailed tips on passing CFA Level 2 here.

Happy studying
Joseph Hogue, CFA

Last updated: October 7, 2016 at 3:34 am

Best Places to Study for the CFA Exam

Find the perfect spot for studying the CFA curriculum to remember more on test day

Hopefully you’ve already found your perfect CFA study location but just in case you still need to find a place for that crucial last-month studying, I thought we would look at the best places to study. Put your mind to it and you could study just about anywhere but a great study location will help you master the material and get every point possible.

Even if you’ve already got a study spot for your CFA journey, read through the points to a great study location and ask yourself if your study place is all it could be. You might be able to improve your hideaway or might even decide to look for another.

What Makes a Great Study Location?

Most study locations have one of two problems, too many distractions…or not enough distractions. Sounds confusing but consider the phenomenon of state-dependent learning. This is the idea that are brains can be trained to recall things depending on an environment, whether you like it or not. Study exclusively in a super-quiet space and you might find it maddening trying to recall things on the test in the exam room. This means your ideal study location is going to be some place public but where people are generally quiet.

A great study location should be comfortable but not too much so. You should have access to a chair that won’t annoy you after a few hours on your backside but not one so comfortable that you fall asleep. Find somewhere with upright chairs (no beanbags!) and tables or desks.

You don’t have to keep just one study location for the exam. Using a few different places might help you deal with different distractions and recall the curriculum no matter where you study. Evaluate your study performance each day on the way home, deciding if you need a different location or what you can do at your current spot.

Besides finding the perfect study location, don’t overlook finding the perfect time to study as well. If you aren’t comfortable getting up early Saturday morning to study…you might want to start practicing. I used Saturday mornings for the month before the CFA exam to take practice exams and see where I needed more work in the curriculum. By the time I went to the real exam, it was like I sat for it several times already.

Comparing the Best Study Locations for CFA Candidates

Library – This one is always first on the list of best study locations. The public but quiet spot mimics a testing environment perfectly. Many libraries even have different options like cubicles, study rooms, tables and couches. If you don’t have a library nearby, a bookstore can work just as well.

Coffee Shops – these will test your ability to ignore distractions and the availability of caffeine is a big plus in my book. Every once in a while, someone will walk in that wants to be the center of attention and will throw you off your concentration. It’s not a great study location but nice for a change of pace.

Classrooms – can make for good study locations if the school will give you access during off-hours. You might not get as many distractions as you will during the CFA exam but the environment will be very similar otherwise.

Public park – Studying outside can be peaceful if you live in the suburbs but it’s tough to lay out everything and you’ll probably have to sit on the ground. Staying awake can be a problem, especially after studying a couple of hours, and the weather can interrupt your whole day.

Maybe it’s not strictly a study location but have you considered a study-vacation? This is my favorite CFA study strategy and usually reserved for the last week before the exam. Go somewhere for a few days or more, whether 100 miles away or thousands of miles. Turn off the cell phone and don’t check your email. Set an aggressive 10-hour daily study schedule and relax the other six hours enjoying the sites. Your hotel room is an ok study location but try out a few parks and the nearest library as well. It’s the perfect combination of hardcore studying and relaxation before the exam.

Now for the worst study location, your own home! Ok, so maybe it’s better than trying to study in the middle of a rock concert but the home can be a crappy place to study. I understand it’s easy and there’s no travel time but there are just too many distractions at home. From talking to family or friends to grabbing a ‘quick’ bite to eat, you’ll lose half of your study time to little breaks. If you can get to one of these other study locations in 20 minutes or less, go for it.

‘til next time, happy studyin’ wherever you are!
Joseph Hogue, CFA

CFA Level 1 Curriculum Review: Financial Statement Analysis

Reading 28 in the CFA curriculum combines the financial statements with key ratios and analysis

This is the fifth week of our CFA Level 1 review of the financial statement material. Reading 28 is your first look into the financial statement analysis and techniques that will make up a big portion of your CFA level 2 exam. In all, financial reporting and analysis accounts for 20% of your level 1 points and up to 20% of the second exam.

Check out the introduction to CFA Level 1 Financial Statements
Check out the CFA Level 1 Income Statement Review
Check out the CFA Level 1 Balance Sheet Review
Check out the CFA Level 1 Statement of Cash Flows Review

Some of the ratios and financial analysis techniques you’ll see in reading 28 have already been discussed in the separate readings on each financial statement. Besides specific techniques used in analysis, pay attention to assumptions used in different techniques and the limitations of each method.

Ratios and Common-Size Financial Statement Analysis

Ratios in financial statement analysis offer a way to standardize information and compare results across companies. It can be used to compare current results with past performance as well. Ratio analysis is limited across companies because each might operate in a slightly different product category or market. Differences in accounting practices can distort ratios and there’s no definite set of ratios that will tell you all you need about a company.

Activity ratios measure management efficiency in day-to-day operations. I’ve included some of the most common ratios used below. Activity ratios are also called asset utilization ratios. Notice that when you use Balance Sheet data in a ratio with another financial statement, you need to take the average of the beginning and ending number reported on the Balance Sheet.

cfa activity ratiosSolvency ratios measure the firm’s ability to meet long-term obligations. Liquidity ratios measure the firm’s ability to meet short-term obligations. Pay attention to the Cash Conversion Cycle which reflects the number of days a company’s cash is tied up in the operating cycle. The conversion cycle equals the number of days inventory plus days receivable outstanding minus the number of days accounts payable outstanding.

Understand the difference between operating leverage and financial leverage. Operating leverage comes from using fixed costs in the company’s business and magnifies the effect of sales growth on operating income. Financial leverage comes from the use of debt and magnifies the effect of changes in EBIT on net income.

cfa debt and liquidity ratiosProfitability ratios measure overall performance and margins. Gross, operating and net margin are used often to show different ideas of profitability.

cfa profitability ratiosIt may seem like a lot of ratios to memorize but they are fairly easy to remember after some repetition. Write the ratios and a brief explanation on some flash cards and review them each day until you’ve mastered the concept.

Common-size financial statement analysis is helpful in spotting trends within a company’s results as well as comparing accounting line items across firms. A horizontal common-size statement compares an accounting item like sales or operating expenses against itself from another year. It’s helpful in finding growth across time in each line item. A vertical common-size statement compares an accounting item against another line in the same year, usually against sales or total assets. It’s helpful in comparing the proportion of a line item in one company against another.

For common-size analysis on the balance sheet, you’ll use total assets as the common item. For analysis on the income statement, sales are used as the common item for comparison.

There’s quite a bit more in reading 28 including DuPont Analysis and some important ratios for equity analysis. All the ratios in the reading could easily show up on the CFA exam since they’re pretty easy to test in a quick question. The best way to approach the material is to understand the concept of the ratio. Instead of just rote memorization of the equation, understand what the components are and how they relate to each other. You’ll find it much easier to remember the mountain of ratios and equations for the exam.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 2 Study Plan and How to Get the Most Points

With just under 21 weeks left to the 2016 CFA exams, now is a great time to get started on your CFA Level 2 study plan. What? You don’t have a study plan?!?

Don’t worry, a smart study plan to pass the CFA exam doesn’t have to be a complicated or stressful plan. In fact, start now and follow the plan below and it could be a rather relaxed experience. With nearly five months left to study, you can dedicate each week to a study session and will still have time for topic reviews and those all-important mock exams.

Other candidates will tell you to wait a few weeks, that you’ve got plenty of time before you need to start your 2016 CFA study plan. Don’t believe them! Start now and be one of the candidates that pass the exams!

A Timeline for your CFA Level 2 Study Plan

The timeline for your 2016 CFA study plan is fairly simple. We want to cover each of the 18 study sessions each week over the next eighteen. Covering just one session per week gives you the time to really hit the material multiple times and commit it to memory. Remember, most people need to see something upwards of seven times for it to be committed to long-term memory.

Some CFA Level 2 study plans will suggest reading the study sessions out of order, whether mixing easy and difficult topics or some other method. I always just read the curriculum books in order but you can read in any order you choose. The order of the books does a good job of building up to the more difficult material so you have the knowledge to tackle more complex ideas when you get to them. Make sure you read the topic readings in order.

Every six weeks, you should take a 60-question exam on the sessions you’ve covered. This can be done by putting together end-of-chapter questions or more easily with a question bank of practice problems. This is going to help refresh the material and measure your mastery of the curriculum.

Cover each study session in a week and you’ll have nearly three weeks left over before the 2016 CFA exams. You’ll use this time to work mock exams to measure your overall retention and review the most important material. Taking one or two mock exams each week before the actual exams will help you prepare physically for the six-hour tests as well as guide your study plan for areas where you still need work.

How to Study for your CFA Level 2 Study Plan

The best study plan combines active and passive learning techniques in repetition. Passive learning involves activities like reading the curriculum or watching a video. It’s an easy way of studying but you don’t retain as much information as you do when you use active learning techniques like working practice problems and flash cards.

The best study plan always starts with reading the CFA curriculum. Resist the temptation to jump straight to condensed notes, they can’t offer all the material and you’ll end up missing some critical points.

After you’ve read through a study session, work the end-of-chapter problems to measure your retention level. Then review study notes on the section to reinforce the key points.

Use a test bank of questions to work another set of practice problems. These are the best resource you can use because they get you actively thinking about the material and mentally ready for the exams.

Review the study session one more time with brief Smart Summary cards of the material and work any difficult concepts on flash cards. You can buy pre-written flash cards but the most effective method is to write your own. You’ll remember more of what you write down yourself and will save money.

Do this cycle for each study session in your CFA Level 2 study plan, repeating it each week.

CFA Level 2 Study Plan

CFA Level 2 Study Plan

How long each study session takes will depend on how quickly you read and will vary on some of the more difficult topic areas. You will probably be able to read through Ethics relatively quickly but may need more time on derivatives and other topics. Do not rush through a study session and make sure you hit each step in the cycle.

This CFA Level 2 study plan won’t guarantee that you pass the exam in June but it will give you plenty of time to master the material. Covering each study session in multiple formats will help you commit it to memory and you should be able to recall everything on the exam.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: October 6, 2016 at 4:23 am

CFA Level 2 Changes 2016: CFA Curriculum Updates

Miss these CFA level 2 changes in the 2016 curriculum and risk missing out on those important few points that could get you a passing score

The CFA Institute has published its curriculum changes for the 2016 exams. The CFA level 2 changes for 2016 are fairly small except for two study sessions. There are no changes to the topic weights as there were last year. I have always suggested candidates get a jump on studying by reviewing prior year curriculum before their own books arrive but you have to be ready for the changes.

You can download a pdf copy of the CFA level 2 changes for the 2016 curriculum by clicking through this link. The curriculum changes are available in a combined document or individually for each of the 18 study sessions.

A word of warning to any candidates comparing the 2015 LOS posted on the CFA Institute website. Many of the author names for readings on the document are incorrect. Comparing the pdf with the 2016 CFA Level 2 LOS will appear that authors have been changed on the readings but it’s not the case.

CFA Level 2 Changes in General

Working through the new readings and LOS for the CFA level 2 changes for 2016, I was just about ready to comment on how little had changed…until I got to the final study session.

In fact, other than in SS18 Portfolio Management, very little has changed from the previous year’s curriculum. There were only two wording changes that I could find in the old LOS along with less than ten new LOS. There is also one new reading in a new subject.

2016 CFA Exam Topic Weights

2016 CFA Exam Topic Weights

And then you get to SS18 that is almost completely new with three new readings out of four. Make sure you master the new Reading 12 in SS3 but spend as much time as possible studying the new material in Portfolio Management.

CFA Level 2 Changes by Study Session

Study session 3 (Quantitative Methods) includes a new reading, reading 12 – Excerpt from “Probabilistic Approaches: Scenario Analysis, Decision Trees, and Simulations”. Within the new reading are seven new LOS so make sure you spend some time on the excerpt and understand the material.

Understand that from the inclusion of the new Reading 12 in SS3 to Reading 46, the numbers for readings do not match up in the new CFA level 2 curriculum (i.e. old Reading #40 corresponds to new Reading #41).

LOS 6i of Reading 20 (Multinational Operations) includes a wording change from, “…sales affect earnings sustainability.” to “…sales affect the sustainability of sales growth.”

LOS 14c of Reading 43 (Term Structure and Rate Dynamics) is new and requires you to describe how zero-coupon rates can be obtained by bootstrapping.

LOS 14g of Reading 43 includes a wording change to, “…swap spread for a given maturity,” from “…swap spread for a default-free bond.”

LOS 14m of (old) Reading 44 (Embedded Options) – “calculate the value of a capped or floored floating-rate bond” has been removed.

Reading 46 of Study Session 15 “Introduction to ABS” and its nine LOS have been moved to the CFA Level 1 Exam and are no longer in the CFA level 2 exam.

The Institute has almost completely revised the readings in SS18, Portfolio Management. Three readings have been replaced and only one remains the same from last year. Readings 53 – 55 are new and must be studied in-depth. The three new readings bring with them 26 new LOS.

Again, other than the new reading in SS3 and SS18, there are not many changes to the CFA level 2 2016 curriculum. Make sure you master the material in these new readings and be prepared to answer the LOS on the exam.

Until next time, happy studyin’
Joseph Hogue, CFA

Last updated: July 18, 2016 at 16:38 pm

Performers spreading joys among a diverse and random group of people - Copyrights FinQuiz.com

Performers spreading joys among a diverse and random group of people – Copyrights FinQuiz.com


Happy Holidays and a Prosperous 2015 from FinQuiz

Another year has almost passed and I just wanted to wish all of our readers Happy Holidays and a prosperous new year. We’ve been running the FinQuiz blog for nearly three years now and the support from candidates has been amazing. Hundreds of thousands of candidates have clicked through to the FinQuiz blog and we’re looking forward to continuing that success with great CFA exam advice that will bring hundreds of thousands more to the blog over the next couple of years.

Our Community of Candidates is the Best Holiday Gift

Since 2012, more than 200,000 people have clicked through to the Finquiz blog and viewed more than 600,000 pages of CFA study tips and curriculum notes. That loyal and regular support by candidates like yourself is the best holiday wish we could imagine.

Almost as great as the sheer number of candidates that have visited the blog has been the reach to all corners of the globe. The blog has been accessed from 201 countries from Albania to Zimbabwe.

The feedback from CFA candidates has been great and has really motivated me in our weekly blog posts. Not only have candidates shared their success on the exams but have also provided valuable feedback that helped us improve the notes and question bank.

“I managed to pass my Level 3 exam this round and the team at FinQuiz was instrumental to my success. Thanks to the wealth of questions available in your question bank, my item set scores are significantly better in this attempt. Joseph’s blogs are not only a source of inspiration, they also helped me in pacing the materials week by week.” Kah Juay Lee, CFA (Passed CFA Level III, 2013)

Of course, the blog is our way of communicating with candidates and putting out the most important information on the exams but it all is in support of our unique system of curriculum notes and exam prep packages. The unique system of notes rather than curriculum substitution has helped candidates beat the abysmal pass rate across the exams.

“Without the help of FinQuiz, I do not believe I would have scored >70% in 8 of 10 areas. FinQuiz tested the difficult areas that other question-banks will not cover. This boosted my confidence and clearly helped me on exam day.” David Young (Passed CFA Level II, 2010)

Upward for 2015

We’re not resting on our past successes. We have some great plans for 2015 and ideas for tips and products that will help every one of our candidates pass the CFA exam. We will start leading up to the June 2015 CFA exams in June with a recap of the curriculum changes and your basic strategy on the exams.

Each week on the blog, you’ll find all the best advice and tricks to get the most points possible on the CFA exams. We’ve tried to make the blog relevant to candidates even beyond the exams with regular posts on career advice, networking and using the designation to the fullest.

We’re always here for you and love to hear from candidates. Send a note if you have any questions or comments and keep clicking through each week for more blog posts.

‘til next time, Happy Holidays!
Joseph Hogue, CFA

Level 2 CFA Curriculum Changes 2015

The readings and Learning Outcome Statements (LOS) are out for the 2015 CFA curriculum and there have been some significant changes. Make sure you download the curriculum outline and new LOS from the CFA Institute website.

The most surprising change has been a modification of the topic area percentage weights on the exams. The previous topic weights had been the same for years, before I was a candidate, and no one really saw the changes coming. The actual changes are relatively marginal but still surprising.

Level 2 Changes

The topic weight for Ethics & Professional Standards has increased from a fixed 10% weight to a range of 10% to 15% on the exam. The range on Financial Reporting & Analysis has been tightened to 15% to 20% of your exam score, slightly decreasing its potential importance from a high of 25%. The importance of Equity Investments has also decreased with a new weighting range of 15% to 25%, from 20% to 30% previously. The range on Alternative Investments decreased to 5% to 10% (5% to 15% previously) while the range for Fixed Income Investments increased to 10% to 20% (from 5% to 15% previously).

There are six new readings to the Level 2 exam (one in FRA, one in Corporate Finance and four in Fixed Income) while 10 readings have been removed (two in Ethics, two in FRA, one in Alternative Assets and five in Fixed Income).

New Readings:

(20) Evaluating Quality of Financial Reports
(25) Corporate Performance, Governance and Business Ethics
(42) Term Structure and Interest Rate Dynamics
(43) Arbitrage-Free Valuation Framework
(44) Valuation and Analysis: Bonds with Embedded Options
(46) Introduction to Asset-Backed Securities

Dropped Readings:
(3) CFA Institute Soft Dollar Standards
(10) Prudence in Perspective
(22) The Lessons We Learn
(23) Evaluating Financial Reporting Quality
(43) Investing in Hedge Funds: A Survey
(46) Term Structure and Volatility of Interest Rates
(47) Valuing Bonds with Embedded Options
(48) Mortgage-Backed Sector of the Bond Market
(49) Asset-Backed Sector of the Bond Market
(50) Valuing Mortgage-Backed and Asset-Backed Securities

The Ethics & Professional Standards topic has gotten a little easier with the removal of some supplementary readings. You still have the case studies but almost all the material is a repeat of what you saw at the Level 1 curriculum. The new edition of the Code and Standards is not materially different from the previous edition. Some of the standards have been modified to include a more proactive requirement, i.e. the need for supervisors to take positive steps to promote compliance rather than just prevention. The new chapter on ‘Ethics and the Investment Industry’ provides a strong argument for ethical conduct and integrity of the markets.

If you compare last year’s readings with the 2015 readings, you’ll notice that many have been changed rather than necessarily added or dropped entirely. This is good news for repeat candidates since it means that the LOS have not changed as dramatically as the readings. Of all the changes, I would probably pay the most attention to Fixed Income. The readings have been changed significantly and the topic weight on the exam has increased as well.

The common belief is that there is a higher chance of new material, i.e. new readings, appearing on the exams. I am not sure this is true or if it is even intentional by the Institute if it does happen. I would still recommend focusing on those topic areas with the most weighting whether they include new readings or not. The Level 2 CFA exam is all about the details and formulas. Where the Level 1 exam was about ‘why’ things are done, the Level 2 exam is about ‘how’ they are done so make sure you are able to work through formulas and processes.

‘til next time, happy studyin’
Joseph Hogue, CFA

Free Cash Flows and the Level II CFA Exam

I’ve had quite a few questions on the Free Cash Flow material for the level 2 CFA exam so thought I would put together a post on the topic. Free cash flow is an extremely important measurement and you will need it extensively in the equity section of the exams as well as in your professional career. It represents the cash available to either equity investors or all capital providers after all working capital and fixed capital needs have been reduced.

Free Cash Flow to the Firm (FCFF) is the cash flow available to all capital providers (debt and equity) and equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed capital + after tax interest expense

FCFF is discounted at the weighted average cost of capital (WACC) since it is the after-tax cash flow to all suppliers of capital.

Free Cash Flow to Equity (FCFE) is the cash flow available to common shareholders and equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed +/- net borrowing

  • Notice that FCFE is FCFF except without adding back interest expense and taking net borrowing into account.
  • Understand how to arrive at FCFE or FCFF with CFO
  • FCFF = CFO + INT (1-t) – invest fixed capital
  • FCFE= CFO – invest fixed capital +/- net borrowing +/- net change in preferred shares

FCFE is discounted at the required rate of return for equity since it is the cash flow only to equity shareholders. Using the WACC for FCFE will overestimate equity value since the weighted average cost will be lower than the cost of equity.

FCFE is a more direct way to value equity, so preferred but FCFF may be preferred when the company has a volatile capital structure or is highly leveraged.

The most difficult part in FCF calculations, for me, was the adjustments to net income to arrive at FCFF. Remember: depreciation, amortization, restructuring expenses, losses on fixed asset sales, deferred tax liabilities, after-tax interest expenses and preferred stock dividends are all added back to net income. Any gains on the sale of fixed assets, the amortization of long-term bond premiums, deferred tax assets, and investments in FC and WC are all subtracted from net income.

It’s a pain but you absolutely have to understand and be able to calculate all the approaches of FCF estimation: net income, net cash flow, EBIT, EBITDA, and FCFE from FCFF. Start with the calculation from net income to get a good feel for the adjustments and what is being built into FCF, this should make the other equations more intuitive. Not only will practicing these formulas help get you points on the exam but they also help with a better understanding of the Statement of Cash Flows and how funding works for a company.

FCF models for valuation are most appropriate when the company does not pay a dividend and/or when the investor has a controlling share or influence in the company. FCF models may not be as appropriate for fast-growing companies with high capital expenditures and negative free cash flows.

As always, try to first understand the basic concept of what FCF means and what is happening in the formulas. Understand what non-cash items and capital expenditures are on the Statement of Cash Flows and why they added or subtracted to arrive at free cash flow. Understanding the accounting in terms of why things are adjusted instead of just numbers and symbols will go a long way to your success on the exams and as an analyst.

As with all topics, you need to understand the major difference between important concepts (i.e. FCFE versus FCFF) and when it is most appropriate to use each. Also understand the advantages, disadvantages and assumptions within the models. Understanding these conceptual ideas will get you a lot of the points even if your memory on the formulas fails you.

Less than a month to the exam, let me know if you have any questions and good luck.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: July 18, 2016 at 16:26 pm

Making Level I Success a Step to Level II

If you’re a CFA level 1 candidate, your top priority right now is to pass that first hurdle and enjoy a well-earned six months of rest. The last thing you want to think about is putting in your time on the next two exams.

But if I told you that there was something you could do while studying for the CFA level 1 exam that would save you a lot of time next year, would you be interested?

You bet you would!

Remembering a few key points while studying for the first exam could help you pass the level 2 exam and even give you a head start on the third exam as well.

Relationships between the CFA exams

The secret is understanding the related material across the exams and what you need from one exam to the next. While the topic areas across all three exams are all related to an extent, there are a few in which your work on earlier exams is absolutely imperative to passing.

Ethics and Professional Standards is probably the most consistent across all three exams. You will see a couple of new sections in the level 2 and 3, but the core material is exactly the same. The topic area is worth more nearly 12% of your total score across all three exams so definitely points you can’t afford to miss.

Not only is the topic extremely important across the exams, it’s been my experience from candidate comments that it is the one they are most often disappointed by on the first exam. Candidates assume they are ethical people and will be able to pick the correct answer out of the three possibles. They neglect the section and then are surprised at how difficult it is on the exam. Spend a little extra time on this area, do the end of chapter problems and save yourself a ton of time and stress in the next two exams.

Quantitative methods is another topic where mastery of the CFA level 1 curriculum will pay off big time on the second exam. While it is not a high-point section, only 12% of your first exam and 5% – 10% of the second, understanding the material in the CFA level 1 is critical to do the work on the next exam. The level 2 curriculum usually even includes optional refresher material for those candidates that didn’t learn or forgot the prior material. Think of it as the difference between two mathematics courses, one teaching the basics of multiplication and the other moving on to algebra. You would be absolutely lost in the algebra class without mastering the prior course.

Financial Reporting and Analysis is one of two or three core topics to the entire curriculum and worth more than a fifth of your first two exams. The readings on the financials statements in the first exam must be mastered to be able to do the intense analysis work in the second exam. Talk to almost any level 2 candidate and they will tell you that one of the hardest parts of the exam is the FRA material, especially intercorporate investments, multi-national operations and pensions. To be able to understand these readings, you must understand the relationships between the financial statements which is Level 1 material. Save yourself the time of reviewing this by mastering it early.

Study session 14 in the Equity Investments topic area will also be a very important reading for progressing to the level 2 exam. In fact, it looks like a lot of the level 1 material is repeated in the level 2 curriculum. Equity Investments are a quarter of your total score at the second level so you want to be ready for the topic.

The usual disclaimer applies that you cannot afford to completely neglect any topic area. You will need around 70% on your exam to pass to the next level. These exams are extremely difficult on a mental and physical level so do not expect to get all the points in any one section. Spend enough time on the secondary topic areas so you can get at least 60% or more and then focus on the higher-point and higher-importance sections.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: July 18, 2016 at 16:59 pm

Do Not Let the CFA Level 2 Exam Surprise You

The pass rate for the CFA level 2 exam has only been lower than that of the first exam in three of the last 10 years. For many candidates, that is a welcome relief after a grueling introduction to the exams and it must mean that the second exam is easier. Right?

Wrong! And it catches a lot of candidates off guard.

While the CFA level 2 exam may indeed be easier for a few, most candidates find it incredibly difficult especially compared to the CFA level 1 exam. Which exam is the most difficult for you will obviously depend on your own abilities but you need to go into the second exam knowing exactly what you are facing.

Quantitative Monster

It is often said that the CFA level 1 curriculum is a mile wide and an inch deep because it covers a huge range of material but really only teaches to the basic ideas within each. The CFA level 2 material covers the same topics but seems to focus more on the detail within a few. While the range of material can still seem daunting, candidates usually agree that the level two curriculum is a mile deep and maybe a few feet wide (to paraphrase the saying).

This becomes a little clearer looking at the topic weights across the exams. While the first exam is more evenly spread out, the second exam is more focused in a couple of topics. In fact, Financial Reporting & Analysis and Equity Investments alone will account for between 35% to 55% of your entire score.

This is obvious enough to anyone preparing for the exam. What is not so obvious is the quantitative difficulty you will see on the exam. Those problem sets are a monster!

Given that nearly half of the exam could be from just two topic areas, I hope I don’t have to tell you where you should be spending your time. You absolutely must know the FRA and Equity material, especially the formulas.

We covered some of the most important formulas on last year’s exam in three posts (First, Second, Third) and linked here. Almost all will still be applicable to this year’s exam so feel free to look through the posts for hints on each.

There’s two things you can do to help get through the formulas.

  • First, you need to understand what is conceptually happening in the formula. Trying to understand the myriad of symbols is crazy. If  WACC = (Vd/(Vd +Vce))rd (1-t) + (Vce/(Vd+Vce))rce) doesn’t make you go cross-eyed you are a stronger person than I am. Think about it intuitively and it makes sense. The overall cost of a firm’s funding capital is the cost and proportion of equity and debt. The percentage of each funding type relative to the total is multiplied by its cost. Debt is tax advantaged, so you need the after-tax cost.
  • Secondly, you have to work these formulas through practice and repetition. One of the most popular posts here shows that active learning (engaging the material through practice and conversation) allows you to remember much more than passive learning. The best way to approach tough formulas is to put them on flash cards. We covered the importance of flash cards and why you should make your own set in the previous post.

Just because a higher percentage of candidates usually pass the second exam than the first doesn’t necessarily mean it is easier. Think of it this way, candidates are fully aware of the immense challenge presented by the exams after the first test and still less than half typically pass the second exam. That should give you an idea of difficulty on the CFA Level 2 exam.

The good news is that tens of thousands of candidates pass the exam every year and you can too. Focus on those formulas, especially in the high-point topic areas, and you will do well. Less than two months ahead of the CFA exams. Be ready.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: July 18, 2016 at 16:40 pm

Help! I passed all three exams but the Institute denied my charter!

“I got that email that every candidate waits for saying that I passed the Level 3 exam and was able to submit my application for membership to the CFA Institute and receive my charter. I was so happy I spent the next hour calling and emailing friends and family. My happiness was quickly turned to pain and disappointment a couple of months later when my application was denied!”

This is an excerpt from an email I received last year in December and is pretty typical of ones I get each year. The problem is almost always the same, lack of approved work experience.

Before you receive your charter and are approved for Institute membership, you must:

  • Pass all three exams
  • Have two sponsors fill out the Institute’s      sponsorship application, one supervisor and one member of the local CFA      society
  • Meet the requirements for 48 months of ‘qualifying’      work experience
  • Pay member dues and sign the Professional Conduct      Statement

The requirement for 48 months of ‘qualifying’ work experience catches more candidates than you would think. The Institute fairly narrowly defines ‘qualified’ and will deny your application if your experience does not fit the mold.

‘Qualifying’ Work Experience

Below is the guidance from the Institute on what is considered ‘qualifying’ work experience.

  • Evaluating or applying financial, economic, and/or statistical data as part of the investment decision-making process involving securities or similar investments (e.g., publicly traded and privately placed stocks, bonds, and mortgages and their derivatives; commodity-based derivatives and mutual funds; and other investment assets, such as real estate and commodities, if these are held as part of a diversified, securities-oriented investment portfolio).
  • Engaged in responsibilities and/or producing work or work product that informs or adds value to those decisions.
  • Supervising, directly or indirectly, persons who practice these activities.
  • Teaching such activities.

The problem is that the definition provided is fairly broad while the actual criteria used in judging applications is more narrow.

In fact, my first application for membership in 2011 was denied for lack of experience. I was denied credit for my three years of work as a financial analyst since my role in the investment decision-making process was not clear.

Follow the Learning Outcome Statements

First, if you are a level one or level two candidate then you’re in luck and still have a few years to get the experience you need. If you are working in a front-office position and you’re job is directly involved in the decision-making process, you’re also in luck and shouldn’t have a problem.

If you do receive that disappointing letter, you can always provide more detail on your job duties. Focus on the learning outcome statements, especially those in the level 3 exam, and how they fit with your job duties. Every company makes investments of resources in projects and most personnel help in the decision-making process in some way. You just have to find your place in the process. After providing more detail on my work experience, including a rewrite of duties more closely related to the exam LOS, I was approved for membership and received my charter.

If you are not approved for membership even after re-applying, it’s not the end of the world. You will be given affiliate member status and will enjoy all the benefits of Institute membership but will not be able to vote. Leverage your ‘charter pending’ status into a job where your duties directly affect the decision-making process and reapply when you meet the 48 months requirement.

‘til next time, countin’ the days to start the 2014 study season
Joseph Hogue, CFA

Last updated: July 18, 2016 at 16:35 pm

2014 Level 2 CFA Exam Changes

The changes to the 2014 CFA Level 2 exam are not as extensive as we’ve seen in the past but there are a few important differences. There are seven new readings and a few ones that have been dropped. All the new readings will have new LOS, though they may be similar to past LOS.

If you’re new to the exam, I wouldn’t change my study schedule too much for the curriculum changes but make sure you have a good grasp of the material. Those repeating the exam will want to focus on the new material since most of the old material will be relatively fresh in your mind.

The Standards and ethics material is the same next year as it has been in the past.

The material in quantitative methods (Study Session 3) and economics (Study Session 4) are basically the same, though some of the LOS have been split or combined but this won’t change the ideas or formulas that you need to know.

Study Session 6, Financial Reporting and Analysis, includes the same three readings (19-21) but they have been updated from last year. LOS 21b and 21h-j have been added and require a more detailed understanding of currency transaction exposure and multinational accounting.

Study Session 8, corporate finance, has not changed though some of the LOS have been split, combined or have slightly different wording. Again, these changes really do not affect what you need to study or understand. Focus on the bigger changes.

The Lessons we Learn, reading 22; Study Session 7 has also been updated

Study Session 11, Equity Valuation (Industry and Company Analysis) has seen the most changes with the addition of two new readings; Reading 33, “Your Strategy Needs a Strategy,” and Reading 34, “Industry and Company Analysis.”

The two new readings strike me as very similar to the Five Forces reading, more management-related than the rest of the curriculum. As an analyst, you need to be able to understand business models and management perspective but a lot of this stuff always seemed too theoretical to me. Easy to remember though.

Reading 44, “A Primer on Commodity Investing,” has been added to Study Session 13, Alternative Investments. The material is fairly close to that in the commodities reading that was dropped from the Level 1 curriculum this year. This happens often where the Institute moves the focus of material from one year to another. The LOS in the new reading look fairly basic and it shouldn’t be a problem for candidates.

Fundamentals of Credit Analysis (Reading 42, 2013) in the Fixed Income material has been replaced by Reading 45, Credit Analysis Models in Study Session 14. While the LOS have changed, they appear to cover mostly the same ideas and concepts. If anything, the new LOS are a bit more quantitatively focused.

Credit Derivatives: An Overview (Reading 53, 2013) has been replaced by Reading 56, Credit Default Swaps in Study Session 15. The new material actually looks a little easier because it is more narrowly focused on Swaps rather than all credit derivatives.

Study Session 18, Portfolio Management has also seen some pretty big changes. The Theory of Active Portfolio Management (Reading 55, 2013) has been dropped and two new readings have been added; Reading 58, “Residual Risk and Return: The Information Ratio” and Reading 59, “The Fundamental Law of Active Management.” Both of these new readings turn the focus to a quantitative approach to active management from last year’s focus on theory.

That concludes our review of the changes to the three exams for the 2014 season. We’ve still got a while before you need to start worrying about a study schedule so we’ll probably cover some miscellaneous topics or answer some questions in the coming weeks. Let me know if there’s anything you want covered.

‘til next time, take a break!
Joseph Hogue, CFA

Must Know CFA Level 2 Formulas, part 3

This is the last of three posts covering the must know formulas for the Level 2 CFA exam. In this post we’ll cover study sessions 13 through 18. The other two posts can be found here: part 1 and part 2.

SS13- Alternative Investments

The Learning outcome statements say you need to be able to calculate the value of real estate over all three approaches; income, cost and sales but the focus of the curriculum is clearly on the income approach and understanding net operating income (NOI). The cost and sales approach to valuation are fairly simple. Cost is just the total expense of creating a similar property while the sales approach looks at the square foot value of similar properties that have sold on the open market.

Of the three valuation methods using income, the direct capitalization is the most important though you also need to understand the DCF and multiplier methods. The discounted cash flows method is just like any other DCF where you take the cash flows over the life of the investment along with a terminal value and discount them to a present value. The multiplier method involves multiplying the gross income from a property by a multiple derived from sales data on similar properties.

The direct capitalization approach revolves around finding the net operating income (NOI) and a cap rate which is the rate of return required by investors.

Gross rental income minus vacancy or collection losses is the effective gross income. The effective gross minus (utilities, taxes, insurance, maintenance, management and advertising) equals the NOI.

* Remember –financing costs and federal income taxes are not subtracted for NOI because the value is independent of financing and is a before-tax, unleveraged measure of income. Depreciation is also not removed.

The cap rate will usually be given or you will need to calculate it from sales and NOI data from similar properties. Otherwise, the cap rate can be found by (discount rate minus growth rate) as well.

The property value is then NOI/cap rate.

Understand how to arrive at the NAV of a REIT and calculate the NAV per share as well as the concept of Funds from Operation (FFO) and REIT price multiples. Understand the difference between FFO and bottom-line earnings and why FFO is a better metric for REITs.

NAV per share = (market value of real estate company’s assets – market value of company’s liabilities)/number of shares outstanding.

The private equity section is testable as well with formulas for distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI). You also need to know the pre-money and post-money valuation as well as the ownership fraction and price per share in venture capital financing.

DPI= sum of distributions/ cumulative capital called down
RVPI = NAV after distributions/ cumulative capital called down
TVPI (also called the investment multiple) is = DPI + RVPI

SS14- Fixed Income Valuation Concepts

Be sure to understand all the financial ratios in credit analysis like: operating profit margin, debt/EBITDA, EBIT or EBITDA to interest expense, and debt/capital.

Understand that the impact on return may be different for small and large yield changes. The impact on return for small, instantaneous changes is (-modified duration)* the change in the spread, while the impact for a large change in yield is (-modified duration*spread change) plus ½ convexity * (change in spread squared).

You may also need to value a callable or putable bond using an interest rate tree.
constructing a binomial interest rate tree.
1)      Given the coupon rate and maturity, use the yield on the current 1-year on-the-run issue for today’s rate.
2)      Assume the level of rate volatility
3)      Given the coupon rate and market value of the 2-year on-the-run issue, select a value of the lower rate and compute the upper rate. R1,u= r1,l * e2volatility

R1,u is the upper rate (1 reflects the interest rate starting in year 1 and u reflects the higher of the two rates in year 1)
Volatility is the assumed volatility of the 1-period rate

e is the natural antilogarithm, 2.71828
4)      Compute the bond’s value one year from now using the interest rate tree
5)      If the value calculated using the model is greater than the market price, use the higher rate of r1,l and recomputed r1,u and then calculate the new value of the on-the-run issue using new rates. If the value is too low, decrease the interest rates in the tree.
6)      The five steps are repeated with a different value for the lower rate until the value estimated by the model is equal to the market price.

SS15- Structured Securities

Be able to calculate the prepayment amount on a passthrough security given a monthly mortality rate. Remember, the single monthly mortality (SMM) is the prepayment/(beginning mortgage balance – scheduled principal payment)

The annualized SMM is the conditional prepayment rate (CPR) and is 1-(1-SMM)12

SS16- Derivatives: Forwards and Futures

The two study sessions covering derivatives are where the formulas get especially intense. You can’t afford to neglect the material because it is worth between 5% and 15% of your total exam score. Start by understanding the basic concepts behind the formulas to give yourself a chance at an educated guess if you forget the formula itself.

Be able to price equity or fixed-income forward as well as find the value of the contract over its life. Remember, the price of a forward is based on an arbitrage relationship between the contract and the underlying determined by how much it would cost to buy and hold the asset using borrowed funds. Knowing this means that you need the current price, interest rate, any cash flows in or out, and the contract length to be able to calculate the forward contract.  

Forward = (S0 – PV(CF))(1+r)t
You should be able to work through an arbitrage scenario given these data points and the price of a forward contract, first understanding if an arbitrage profit is available then calculating the profit.

Forward rate agreements are also very testable so be able to value a contract. FRA are agreements to pay (or receive) a set interest rate and receive (or pay) a floating rate that is determined at contract expiration.

The payoff on a FRA is = Notational times ( underlying rate at expiration – forward contract rate)(days in underlying rate/360) divided by (1+underlying rate at expiration (days in underlying/360))

It may seem like an intimidating formula but it is really just the difference in rates at expiration multiplied by a time factor relative to the contract length. Make sure you use 360 for the days in a year.

SS17- Derivatives: Options, Swaps, and Rate Derivatives

Being able to calculate synthetic positions using options is a matter of knowing the put-call parity formula.  The relationship says that the value of a call plus the (strike price divided by (1+risk free rate)t) should be equal to the value of a put and the underlying asset.

C0 + (x/(1+Rf)T) = P0 + S0

Rearranging this formula, you can find the price for synthetic positions by putting C0, P0, or S0 alone on one side of the equation.

Be able to calculate the payment to a cap or floor holder.

Payment to cap is the max of either zero or notational*(index rate – cap strike rate)*(days in settlement period/360)

While the payment to the floor holder is the max of either zero or notational*(floor strike rate – index rate)*(days in settlement period/360)

The swaps material can be lengthy and complicated with formulas for the fixed payment, floating payment and for the pricing. Remember that currency swaps involve two different currencies and the notational principal is usually exchanged at initiation.

SS18- Portfolio Management
Portfolio management becomes the focus on the Level 3 exam, so it really pays to learn the material on the second exam to save time next year. The expected return and standard deviation on a two-asset portfolio is a common question and fairly easy. Remember that the return is just the weighted returns of the assets while you’ll need the variance and correlation coefficient for the standard deviation.

Varianceportfolio = w2121+w22 σ22+ 2w1w2(correlation) σ1 σ2
*Remember to take the square root of the variance to get the standard deviation.

Also be able to calculate the expected return on an asset given factor sensitivities and factor risk premiums, which is basically just a regression-type formula.

The formulas in these three posts should get you started on the list of most likely to show up on the exam. While you cannot take a formula sheet into the test with you, it’s a good idea to write one up just to practice the formulas and commit them to memory.

A little over a week left to the exam. 
‘til next week, happy studyin’
Joseph Hogue, CFA

Last updated: October 1, 2016 at 3:20 am

Must Know CFA Level 2 Formulas, part 2

We covered the first five study sessions worth of formulas in last week’s post and will continue with study sessions 6-12 this week. Again, this is not a complete list of every calculation you will need on the Level 2 exam but the formulas in the curriculum that stand out to me as particularly important. At a minimum, you should know these and the conceptual material surrounding their assumptions and strengths/limitations.

SS6- FRA Intercorporate Investments, Post-Employment and Share-based Compensation, and Multinational Operations

Most of the FRA material is more knowing the accounting and procedures rather than complex formulas. Once you know what adjustments or expenses to be made to a beginning entry then the calculations are really little more than addition/subtraction.

The pension material is important here and you’ll see the same accounting in the next exam as well. Be able to calculate the defined benefit pension obligation and the net pension liability or asset. For the ending DBO = Beginning + Service Cost + Interest Cost +/- Past service cost from current amendments +/- actuarial gains or losses in the current period – benefits paid

Be able to calculate the pension expense and economic pension expense as well.

The translation effects on the balance sheet and income statement through the temporal and current rate methods is something that has been in the curriculum for a while and often appears on the exam. Remember, the gains and losses from the use of the temporal method go directly to the income statement whereas the gains/losses from the current rate method go to the CTA in the stockholders’ equity section of the balance sheet. The balancing ‘plug’ number for the current rate method is the cumulative translation adjustment while the plug number for the temporal method is retained earnings and the gain from translation on the income statement.

SS7  – FRA Earnings Quality Issues and Ratio Analysis
This is mostly a conceptual reading with some basic ratios and no real formula work

SS8- Corporate Finance

Economic profit is a fairly important formula here with the other formulas (i.e. market value added, residual income) also easily testable and seen in other sections of the exam. Economic profit is the excess earned over the dollar cost of capital invested.

    • NOPAT = Net operating profit after tax, EBIT (1-tax rate)
    • SWACC  = dollar cost of capital, WACC* Capital
  • Market Value Added (MVA) is the NPV calculation of Economic Profit

Be able to calculate dividends under three dividend policies: Stable, constant dividend payout ratio, and residual.

  • Under the stable dividend policy, a payout is set for long term and the target payout ratio is used to find the expected increase. The expected increase is the increase in earnings times the target ratio times an adjustment factor (the reciprocal of the number of years to adjust the dividend)
  • Under the constant payout ratio policy, the dividend fluctuates with net income and may be volatile.
  • Under the residual policy, dividends = earnings – (capital budget*equity % in capital structure)

SS9- Corporate Finance: Financing and Control
The post-merger EPS is the acquirer’s pre-merger earnings plus the target’s pre-merger earnings divided by the post-merger shares outstanding. Remember that the acquirer may have to issue new shares equal to the target’s market cap divided by the acquirer’s stock price.

The Herfindahl-Hirshman Index is something that comes up frequently but really isn’t too difficult. Just take each firm’s market share times 100 and then squared, then add them all up. Realistic numbers are usually above 500 up to 3,000 so make sure you check your answer.  You’ll need to remember the three levels of concentration and the likelihood of an antitrust challenge (i.e. < 1,000, 1,000- 1,800, >1,800)

You may need to calculate the free cash flows for a target company through NOPLAT. NOPLAT is the unlevered net income plus any change in deferred taxes. FCF = NOPLAT + Noncash charges – changes in net working capital – capex. Don’t forget to discount the FCF to a present value using the appropriate rate.

SS10- Equity Valuation
The weighted average cost of capital is a fairly easy calculation but can cost you points if you rush through it. Don’t forget to use the after tax cost of debt, rate (1-tax rate). It is usually preferred to use the target weights for capital structure rather than the current market value weights when finding WACC.

SS11- Industry and Company Analysis
There are some extremely important and testable formulas in this reading. You should be able to work the dividend discount model solving for any one of the variables in case they ask for the discount rate or the dividend growth rate. Remember, the Gordon growth model is a DDM under the constant growth assumption while the H-model or the multi-stage models assume different growth rates.

Under the Gordon growth, value = (current dividend * (1+growth rate)) divided by the required rate minus growth

The H-model is taking a basic DDM (initial dividend rate divided by rate minus long-term growth) but multiplies in a bonus because of supernormal growth (the difference in rates times half the years plus the long-term growth rate). The second part of the equation is a mathematical attempt at estimating a linear (straight line) decline in growth.

Be able to decompose the return on equity in a DuPont Analysis down to its most basic pieces.

ROE = NI/Sales  * Sales/Total Assets * Total Assets/Shareholders’ Equity

If you forget, just remember that ROE is NI/Equity so all the other variables must cancel out (i.e. sales is denominator in NI/Sales and numerator in Sales/Assets). Remember that these are also net profit margin * asset turnover* leverage.

SS12- Valuation models
Free cash flow is an extremely important measurement and you will need it extensively in the equity section of the exam, especially at level II. It represents the cash available to either equity investors or all capital providers after all working capital and fixed capital needs have been accountable. Basically, it is the extra cash available to owners (of debt or equity) after the company’s future operations have been funded.

Free Cash Flow to the Firm (FCFF) is the cash flow available to all capital providers (debt and equity) and equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed capital + after tax interest expense

Free Cash Flow to Equity (FCFE) is the cash flow available to common shareholders and equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed +/- net borrowing

  • Notice that FCFE is FCFF except without adding back interest expense and taking net borrowing into account.
  • Understand how to arrive at FCFE or FCFF with CFO
  • FCFF = CFO + INT (1-t) – invest fixed capital
  • FCFE= CFO – invest fixed capital +/- net borrowing

Be able to understand and calculate price multiples like price/earnings, price/book, price/sales, and price/earnings to growth on a trailing and forward basis.

Enterprise value multiples like EV/EBITDA or EV/Sales are important along with the other price multiples. Remember, Enterprise Value is market value equity + market value preferred + market value debt – cash & investments.

In its most basic form residual income is net income minus an equity charge or just the income remaining after a theoretical cost of the equity used.  Net Income – (equity capital*cost of equity)

You may see the calculation including NOPAT which is Net Income + the after tax interest expense so be ready for RI = NOPAT- (WACC*Total Capital) as well.

The valuation model using residual income and book value can be lengthy but is absolutely necessary to learn. Go through a couple of examples until you are sure you have it down for the test.

We’ll conclude the Level 2 must know formulas on Friday with study session 13-18. Let me know if you have any questions or think I missed an important formula.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: July 18, 2016 at 16:22 pm

Which formulas are the most important for the CFA Level 2?

There are a ton of formulas you need to know for the Level 2 exam. For me, as with others, it is the most quantitatively intensive test I’ve ever taken.

But do you really need all those formulas, and how do you memorize so much in such a quick time?

In this post and continued through the next two Tuesdays, we’ll look at the most important formulas in the second exam and how to approach the massive amount of material. The usual disclaimer applies, while I have been writing on the exams for quite a while and took them myself, no one knows what will actually show up on the exam. All the curriculum is testable. I can only tell you what I have seen through my own experience and what I have seen on successive versions of the curriculum over the last four years.

We’ll start with a general approach to the formulas then look at each study session to pick out the most important formulas.

Remembering every single calculation from the curriculum is not practical for most candidates and it does seem that the Institute targets some material as more important than others. That said, it is extremely easy to get into the punter’s trap. I call the punter’s trap where you find a tough formula and decide to skip it and focus on easier points instead. Something like punting in football instead of going for the extra yardage. The problem is, once you start doing this it gets easier to do it again and again. Pretty soon, you are skipping a good portion of the curriculum and you are guaranteed some lost points on the exam. Spend the time and get these formulas down.

There’s two things you can do to help get through the tough formulas.

  • First, you need to understand what is conceptually happening in the formula. Trying to understand the myriad of symbols is crazy. If  WACC = (Vd/(Vd +Vce))rd (1-t) + (Vce/(Vd+Vce))rce) doesn’t make you go cross-eyed you are a stronger person than I am. Think about it intuitively and it makes sense. The overall cost of a firm’s funding capital is the cost and proportion of equity and debt. The percentage of each funding type relative to the total is multiplied by its cost. Debt is tax advantaged, so you need the after-tax cost.
  • Secondly, you have to work these formulas through practice and repetition. One of the most popular posts here shows that active learning (engaging the material through practice and conversation) allows you to remember much more than passive learning. The best way to approach tough formulas is to put them on flash cards. Write out a full practice question like those at the end of the chapters. Then work the questions each day. When you are able to do one easily, put it aside so the time necessary each day decreases. You will want to review them all every couple of weeks to make sure you haven’t forgotten any.

We’ll go through each study session to look at the high level important questions but make sure you are doing the end-of-chapter and blue-box questions in the curriculum. If the Institute is taking the time to write out a problem, then they want you to know the formula and you could see it on the exam.

There are no calculations in the first two study sessions, just ethics material but this is extremely important to your overall grade so you may want to review our posts on ethics and standards.

SS2/3 – Quantitative Methods
You need to know how to calculate the sample covariance and correlation coefficient. Learn the basics of the formula but you can do both of these on your calculator so learn how to input the data and you’ll save a lot of time.

You need to know how to calculate a value for a regression model, which is pretty easy by just plugging the numbers into the variables in the formula. The correlation coefficient is just the covariance divided by the standard deviations of each variable. Ryx = COVyx/sysxwith the covariance being the sum of the differences (y- average y)(x – average x) divided by the sample size minus one.

Remember, the slope estimate (b1) is the covariance divided by the variance. What gets most candidates is the various statistics on the ANOVA chart so learn the parts and be able to interpret their meaning.

Predicting the value of a time series or the autoregressive model is similar to the regression model, just plug in the numbers. Be sure you can work a formula with a seasonal lag as well. You may also need to calculate a mean reverting level.

SS4 – Economics
Forex can be tough, especially with the confusion around direct and indirect quotes. You need to be able to calculate the bid-ask spread as well as calculate the profit on a triangular arbitrage. I have included two video explanations to get you started.

A good explanation of Bid and Ask quotes is available on YouTube at:

Cross rates and arbitrage are easily testable and will really test whether you understand forex quotes and calculations. A good explanation of triangular arbitrage is available on YouTube at:

The forward premium or discount on a currency is just the relative difference between the forward and spot price (Fxy – Sxy)/ Sxymultiplied by the annualized time in the contract (12/# of months until settlement)

Interest rate parity is an important concept and the formula is fairly easy. It’s just the relative interest rates (1+rx/1+ry) times the spot price.

SS5 – FRA Inventories and Long-term Assets
You’re required to calculate the effect of inflation or deflation on inventory costs and ratios but I see this as more a conceptual problem. Understand what affect inflation or deflation has on the LIFO or FIFO methodologies and you’ll be fine.

We’ll cover study sessions 6-12 in the post next Tuesday and the remaining sessions in the post after that. We’ll be using the other posts through the next couple of weeks to review strategies for the exams and how to prepare.

‘til next time, happy studyin’
Joseph Hogue, CFA