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Top9CFALevel1FormulasMustread
PostedonNovember15,2016byjosephhogue
PeelingbackthecoveronyourCFALevel1bookscanbeashockatfirst.ThousandsofpagesandhundredsofCFALevel1formulassitin
frontofyouandcanseemoverwhelming.
Beforeyoufreakout,itsnotreallysobad.WhileformulasbecomecrucialontheCFAlevel2examanditsquantitativefocus,theformulason
thefirstexamaremuchmoreaboutlearningrelationshipsandtheprocess.Learnthewhyoftheformulaandyoullrememberhowtoworkit
ontheexameasily.
IthoughtIwouldcoversomeofthemostimportantCFAlevel1formulasandhowtoapproachthemountainofequations.Practiceproblems
andflashcardsaregoingtobeyourbestfriends.Theresreallynosubstituteforworkingformulasoverandoveragainforrememberingthem
ontheexam.Writeoutpracticeproblemsofthemostdifficultandmostimportantformulasandthenpracticethemdailyuntilyoucandothem
easily.
CFALevel1Formulas#1:FutureValueofaSingleCashFlow
Thefuturevalueofcashflowsisnotadifficultformulaandonethatyoulldoonyourfinancialcalculatorbutitsreallyabuildingblocktoalotof
themoredifficultformulasfortimevalueofmoney.Makesureyouunderstandthisbasicformulaandwhatthedifferentnotationsmean.
N
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FVN=PV(1+r)N
i.e.ifyoursavingsaccountearnsinterestata5%rateandyouhave$100deposited,howmuchwillitbeworthin20years?
FV20=$100(1+.05)20
=$265.33
CFALevel1Formulas#2:NPVandIRR
BothNPVandIRRarealsofoundeasilywiththecalculatorbuttheypopupmanytimesinconceptualquestionssoyoureallyneedto
understandtheideabehindeach.RememberthatakeyassumptionofIRRisthatcashflowsarereinvestedatthatrate,whichmaynotbe
realistic.Also,iftherearemultiplecashoutflows,therewillbemultipleIRRsornoneatall.TheremaybeaconflictbetweenNPVandIRR
whenprojectsaremutuallyexclusiveorwhentherearemultiplecashoutflows.Inthiscase,NPVispreferred.
Usingthecalculatorisrelativelyeasy,
Theinitialprojectcostorinvestmentisanegative(outflow)asCF0
CO1throughxarethestreamofcashflowsandenteredasapositive(inflow)
Ifcashflowsareanequalamount,youcanenterthemasF(frequency)
PresstheNPVbuttonandentertheinterestrate
Downarrow
CPTNPV
ForIRR,justpresstheIRRbuttonandCPT
CFALevel1Formulas#3:SharpeRatio
TheSharpeRatioisameasureforadjustingriskacrossinvestmentsandmeasuringreturnonthesamescale.Whilebondsmayofferamuch
lowerrate,aretheyabetterorworseinvestmentthanstocksgiventheirlowervolatility?Itsaprettyeasycalculationandyoullseeitcomeup
inallthreeexamssomakesureyoucanrememberitquickly.
Sharperatio=(AssetReturnRiskFreeRate)/AssetStandardDeviation
CFALevel1Formulas#4:CapitalAssetPricingModel
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TherearealotofflawsintheCAPManditsusedmoreinacademicsbutitisstillaveryusefulformulaandwillappearthroughouttheCFA
exams.Beyondtheformula,youshouldpayattentiontodrawbacksofusingtheCAPM.
Ra=rf+Ba(rmrf)
Therequiredreturn(Ra)istheamountofreturnrequiredgivenaspecificassetsadditionalriskrelativetothemarketandtheriskfreerate.You
multipleanassetsbeta(Ba)bythedifferencebetweentheexpectedreturnonthemarket(rm)andtheriskfreerate(rf).Youthenaddbackin
theriskfreerate.
Thedifferencebetweenthemarketsexpectedreturnandtheriskfreerateiscalledthemarketpremium,theadditionalreturnrequiredfor
takingonmarketrisk.
CFALevel1Formulas#5:DuPontAnalysisofROE
DuPontanalysisbreaksdownthereturnonequity(ROE)intothreecomponents,profitmarginassetturnoverequitymultiplier.
ROE=(NetIncome/Sales)*(Sales/Assets)*(Assets/Equity)
Whichbecomes(NetIncome/Equity)initssimplestform.
Theformulaprovidesanotherlayerofanalysisonwhichtocomparecompanyprofitability.Itsnotenoughtobeabletosaythatonecompany
hasahighreturnonitsshareholderequitybutyouneedtoknowthesourceofthereturn.
CFALevel1Formulas#6:DividendDiscountModels
TheGordonGrowthModel(GGM)isarguablyoneofthemostusedformulasinthecurriculum.Itisasinglestagemodel,assumingthat
dividendswillgrowataconstantrateintoperpetuity.Thegeneralformulais:
Price=Div0(1+growth)/(Rcegrowth)
Animportantnoteisthattherequiredreturnmustbehigherthanthegrowthrateindividendstousetheformula.Thisisnotusuallyaproblem
insinglestagemodelsbecausethelongtermgrowthratewillprobablybefairlylow.Bereadytocalculatesomeofthedatapointsontheexam
(likefindingthediscountratethroughCAPMorthegrowthratethroughROEandthepayoutratio).
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TheGGMisnotappropriatewhenthecompanyisexperiencingsupernormalgrowthforaperiodbeforeitslowstoperpetualgrowth.Forthis
scenario,youneedoneofthemultistagemodels.
CFALevel1Formulas#7:WeightedAverageCostofCapital
UnderstandingandcalculatingtheWACCisanotherfoundationalconceptthatyouwillneedtomaster.Theconceptisprettyintuitive,afirms
costofcapital(spending)isaweightedaverageofthecostfromeachsource(debtorequity).Debtisnormallylessexpensiveandtaxshielded
butcanberiskyathighamounts.
WACC=E/V*Re+D/V*Rd*(1Tc)
TheWACCisequaltothepercentageoffinancingfromequity(E/V)timesthecostofequity(Re)plusthepercentageoffinancingfromdebt
(Rd)timesthecostofdebt,adjustedforthetaxshield.
Usethemarketvalueofdebtorequitywhenavailable.Remember,thecompanyscapitalstructuremaychangeovertimesoitispreferableto
usetargetweightsinsteadofcurrentmarketvalueweights.
CFALevel1Formulas#8:FreeCashFlows
FCFmodelsacknowledgethatinvestorshavearighttoallcashflowsfromacompanyandnotjustthosepaidoutasdividends.Freecash
flowsarethecashgeneratedfromoperationsafterthatneededforcontinuedoperationsisdeducted.
TheadvantageisthatFCFcomparedtodividendmodelsisthatFCFcanbecalculatedregardlessifthecompanypaysadividend.FCF
modelsarealsoappropriateforinvestorsthatmaybeabletoexerciseacontrolpremiumonthecompany.Themajordisadvantageisin
valuingthosecompanieswithhighcapitalexpenditures,makingfreecashflownegativeattimes.
Freecashflowisshowntwodifferentways,FreeCashFlowtoEquityandFreeCashFlowtotheFirm,eachappropriatetotwodifferent
ownershipperspectives.FCFFisthecashflowfromoperationsaftercapitalexpendituresthatisavailabletobothlevelsofownership(debtand
equity).FCFEisthatleftoverafterpayingdebtholders,sincetheyhaveapriorclaim.
FreeCashFlowtotheFirm(FCFF)isthecashflowavailabletoallcapitalproviders(debtandequity)andequals:
Netincome+NetnoncashCharges(depreciationandamortization)InvestmentinworkingcapitalInvestmentinFixedcapital+aftertax
interestexpense
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FreeCashFlowtoEquity(FCFE)isthecashflowavailabletocommonshareholdersandequals:
Netincome+NetnoncashCharges(depreciationandamortization)InvestmentinworkingcapitalInvestmentinFixed+/netborrowing
NoticethatFCFEisFCFFexceptwithoutaddingbackinterestexpenseandtakingnetborrowingintoaccount.
UnderstandhowtoarriveatFCFEorFCFFwithCFO
FCFF=CFO+INT(1t)investfixedcapital
FCFE=CFOinvestfixedcapital+/netborrowing
CFALevel1Formulas#9:TurnoverRatios
Thelastformulaisactuallyaseriesofratiosbutallrelativelyeasytoremember.Thesearetheturnoverratios:accountsreceivable,inventory
turnover,numberofdaysreceivables,numberofdayspayableandnumberofdaysinventory.Youllusethesetocalculatethenetoperating
cycleandallindividualratiosarefairgameontheexam.
Themostimportantthinghereistorememberthatwhenyouarecombiningincomestatementdataandbalancesheetdata,youneedtouse
anaverageofthebalancesheetdata.Forexample,theinventoryturnoverratioisthecostofgoodssold(incomestatement)dividedbythe
averageinventoryfromthecurrentandpreviousperiodbalancesheet.
Mostoftheseformulasarenotdifficultandareprettyintuitiveifyoujustthinkthroughthemforamoment.Youllneedthatdeepunderstanding
ofwhatisgoingonintheformulamorethanyoullneedtheformulaitself.Makesureyouhavethisconceptualmasteryandyoullhaveno
troubleontheCFAlevel1exam.
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Wanttodownloadfullformulasheet?Clickhere
tilnexttime,happystudyin
JosephHogue,CFA
Lastupdated:December22,2016at7:17am
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