## Must Know Level II 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.

• EP = NOPAT – SWACC
• 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

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