CFA Level I - Reading 45

A company increases its value and creates wealth for its shareholders by earning more on its investment in assets than is required by those who provide the capital for the firm. A firm’s WACC may increase as larger amounts of capital are raised. Thus, its marginal cost of capital, the cost of raising additional capital, can increase as larger amounts are invested in new projects. This results in an upward-sloping marginal cost of capital curve. Given the expected returns (IRRs) on potential projects, we can order the expenditures on additional projects from highest to lowest IRR. This will allow us to construct a downward sloping investment opportunity schedule.
The intersection of the investment opportunity schedule with the marginal cost of capital curve identifies the amount of the optimal capital budget. The intuition here is that the firm should undertake all those projects with IRRs greater than the cost of funds, the same criterion developed in the capital budgeting topic review. This will maximize the value created. At the same time, no projects with IRRs less than the marginal cost of the additional capital required to fund them should be undertaken, as they will erode the value created by the firm.

An additional issue to consider when using a firm’s WACC (marginal cost of capital) to evaluate a specific project is that there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project.

The cost of common equity (k_ce) is the rate of return stockholders require on the equity capital the firm retains from earnings.

1. The CAPM approach:
   k_ce = RFR + Beta[E(R_MKT − RFR)]
   
2. The bond-yield plus risk-premium approach:
   k_ce = bond yield + risk premium
   
3. The discounted cash flow or dividend yield plus growth rate approach:
   k_ce = (D₁ / P₀) + g 

In the weighted average cost of capital calculation, the cost of preferred stock must be adjusted for the cost to issue new preferred stock.

To reflect the increased risk associated with investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.
The general risk of the developing country is reflected in its sovereign yield spread. This is the difference in yields between the developing country’s government bonds (denominated in a developed market currency) and Treasury bonds of a similar maturity. To estimate an equity risk premium for the country, adjust the sovereign yield spread by the ratio of volatility between the country’s equity market and its government bond market (for bonds denominated in the developed market’s currency). A more volatile equity market increases the country risk premium, other things equal.

CFA Level I - Reading 44

The capital budgeting process is the process of identifying and evaluating projects where the cash flows will be received over a period longer than a year and has four administrative steps:

1. Idea generation.
2. Analyzing project proposals.
3. Create the firm-wide capital budget.
4. Monitoring decisions and conducting a post-audit.

Capital budgeting projects may be divided into the following categories:

• Replacement projects to maintain the business.
• Replacement projects for cost reduction.
• Expansion projects.
• New product or market development.
• Mandatory projects.
• Other projects. 

1. Decisions are based on cash flows, not accounting income. The relevant cash flows to consider are incremental cash flows. Sunk costs should not be included in the analysis. Externalities should be included in the analysis.
2. Cash flows are based on opportunity costs. Opportunity costs should be included in project costs. These are cash flows generated by an asset the firm already owns, that would be forgone if the project under consideration is undertaken.
3. The timing of cash flows is important. Cash flows received earlier are worth more than cash flows to be received later.
4. Cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when analyzing capital budgeting projects.
5. Financing costs are reflected in the project’s required rate of return. Only projects that are expected to return more than the cost of the capital needed to fund them will increase the value of the firm. 

• The average accounting rate of return (AAR) is defined as the ratio of a project’s average net income to its average book value.
• The profitability index (PI) is the present value of a project’s future cash flows divided by the initial cash outlay.

• Location: European countries tended to use the payback period method as much or more than the IRR and NPV methods.
• Size of the company: The larger the company, the more likely it was to use discounted cash flow techniques such as the NPV and IRR methods.
• Public vs. private: Private companies used the payback period more often than public companies. Public companies tended to prefer discounted cash flow methods.
• Management education: The higher the level of education, the more likely the company was to use discounted cash flow techniques.

The Relationship Between NPV and Stock Price: In theory, a positive NPV project should cause a proportionate increase in the company’s stock price. In reality, changes in the stock price will result more from changes in expectations about a project’s profitability.

CFA Level I - Reading 51

The assumptions of capital market theory are:

• Markowitz investors: All investors use the Markowitz mean-variance framework to select securities. This means they want to select portfolios that lie along the efficient frontier, based on their utility functions.
• Unlimited risk-free lending and borrowing: Investors can borrow or lend any amount of money at the risk-free rate.
• Homogeneous expectations: This means that when investors look at a stock, they all see the same risk/return distribution.
• One-period horizon: All investors have the same one-period time horizon.
• Divisible assets: All investments are infinitely divisible.
• Frictionless markets: There are no taxes or transaction costs.
• No inflation and constant interest: There is no inflation, and interest rates do not change.
• Equilibrium: The capital markets are in equilibrium. 

The market portfolio is the portfolio consisting of every risky asset; the weights on each asset are equal to the percentage of the market value of the asset to the market value of the entire market portfolio. For example, if the market value of a stock is $100 million and the market value of the market portfolio is $5 billion, that stock’s weight in the market portfolio is 2 percent ($100 million / $5 billion).

Since the market portfolio contains all risky assets, it must represent the ultimate in diversification. All the risk that can be diversified away must be gone.

Beta is a standardized measure of systematic risk. Beta measures the sensitivity of a security's returns to changes in the market return.

Relaxing the CAPM assumptions changes the model’s implications.

• Different borrowing and lending rates: The CAPM cannot be derived without equal borrowing and lending rates, unless investors can create a zero-beta portfolio. This puts a kink in the CML.
• Transaction costs: The existence of transactions costs means that the SML is a band (with fairly tight upper and lower bounds on prices) rather than a line.
• Heterogeneous expectations and planning periods: The impact of heterogeneous expectations and multiple planning periods on the CAPM is similar to the impact of transactions costs—the SML becomes a band rather than a line.
• Taxes: Individual investors facing different marginal tax rates will have different after-tax return expectations, so their SMLs and CMLs will be quite different. 

Combining the CML (risk-free rate and efficient frontier) with an investor’s indifference curve map separates out the decision to invest from what to invest in and is called the separation theorem. The investment selection process is thus simplified from stock picking to efficient portfolio construction through diversification.

CFA Level I - Reading 49: The asset allocation desicion

There are four general steps in the portfolio management process:

1. Write a policy statement that specifies the investor’s goals and constraints. Then itemize the risks the investor is willing to take to meet these goals.
2. Develop an investment strategy designed to satisfy the investor’s policy statement based on an analysis of the current financial and economic conditions.
3. Implement the plan by constructing the portfolio, allocating the investor’s assets across countries, asset classes, and securities based on the current and future forecast of economic conditions.
4. Monitor and update the investor’s needs and market conditions. Rebalance the investor’s portfolio as needed.

The policy statement:

• Identifies needs and constraints of the investor.
• Helps investors understand the risk and costs of investing.
• Acts as a guide for the portfolio manager.
• States the performance standards and the benchmark.
• Enforces investment discipline on the client as well as the portfolio manager.

Investment objectives must be stated in terms of both risk and return.
Return objectives may be stated in absolute terms (dollar amounts) or percentages. Return considerations also cover capital preservation, capital appreciation, current income needs, and total returns.
Specifying investment goals in terms of just return may expose an investor to inappropriate, high-risk investment strategies. Also, return-only objectives can lead to unacceptable behavior on the part of investment managers, such as excessive trading to generate excessive commissions (churning).
Risk tolerance is a function of the investor’s psychological makeup and the investor’s personal factors such as age, family situation, existing wealth, insurance coverage, current cash reserves, and income.

Capital preservation is the objective of earning a return on an investment that is at least equal to the inflation rate. The concern here is the maintenance of purchasing power. To achieve this objective, the nominal rate of return must equal the inflation rate.
Capital appreciation is the objective of earning a nominal return that exceeds the rate of inflation over some period of time. Achieving this goal means that the purchasing power of the initial investment increases over time, usually through capital gains.
Current income is the objective of earning a return on an investment for the purpose of generating income. The current income objective is usually appropriate when an investor wants or needs to supplement other sources of income to meet living expenses or some other planned spending need.
Total return is the objective of having a portfolio grow in value to meet a future need through both capital gains and the reinvestment of current income. The total return objective is riskier than the income objective, but less risky than the capital appreciation objective.
  
Liquidity refers to the ability to quickly convert investments into cash at a price close to their fair market value. Liquidity from the investor’s view is the potential need for ready cash. This may necessitate selling off assets at unfavorable terms. 

Time horizon refers to the time between making an investment and needing the funds. Since losses are harder to overcome in a short time frame, investors with shorter time horizons usually prefer lower risk investments. 

Tax concerns play an important role in investment planning because after-tax returns are what investors should be concerned with. The tax code in the U.S., and most other countries, is complex. 

Legal and regulatory factors are more of a concern to institutional investors than individuals, but the investment strategies of both may be restricted due to these constraints. 

Unique needs and preferences are constraints that investors may have that address special needs or place special restrictions on investment strategies for personal or socially conscious reasons.



Several studies support the idea that approximately 90% of a portfolio’s returns can be explained by its target asset allocations. The clear implication here is that differences in returns among asset classes are much more important in determining overall portfolio returns than differences in return due to which specific securities are selected within each asset class. For actively managed funds, actual portfolio returns are slightly less than those that would have been achieved if the manager strictly maintained the target asset allocation. This illustrates the real difficulty of improving returns by varying from target allocations (market timing) as well as of selecting undervalued securities in very efficiently priced markets.
Average asset allocations across countries differ for reasons related to demographics, social factors, legal constraints, and taxation.


One of the first steps in developing a financial plan is to purchase adequate life insurance coverage.

Most experts recommend a cash reserve equal to about six months' living expenses.



Life Cycle:
1. Accumulation Phase: Individuals in the early-to-middle years of their working careers are in the accumulation phase. These individuals are attempting to accumulate assets to satisfy fairly immediate needs (e.g. down payment for a house) or long term goals (children's education, retirement). These individuals are willing to make relatively high-risk investments in the hopes of making above-average nominal returns over time.

We must emphasize the wisdom of investing early and regularly in one's life.

2. Consolidation phase: Individuals are typically past the midpoint of their careers, have paid off much or all of their outstanding debts, and perhaps have paid, or have the assets to pay, their children's college bills. Earnings exceed expenses. The typical investment horizon is still long (20-30 years), so moderately high risk investments are attractive. At the same time, because individuals in this phase are concerned about capital preservation, they do not want to take very large risks that may put their current nest egg in jeopardy.

3. Spending phase: it begins when individuals retire. Living expenses are covered by social security income and income from prior investments, including employer pension plans. They seek greater protection of their capital, at the same time, they must balance their desire to preserve the nominal value of their savings with the need to protect themselves against a decline in the real value of their savings due to inflation.

Their overall portfolio maybe less risky than in the consolidation phase, they still need some risky growth investments (e.g. common stocks) for inflation protection.

A bear market early in our retirement can greatly reduce our accumulated funds. Annuity could be used to transfer risk from the individual to the annuity firm.

4. Gifting phase: It is similar to, and may be concurrent with, the spending phase. Individuals believe they have sufficient income and assets to cover their current and future expenses while maintaining a reserve for uncertainties. excess assets can be used to provide financial assistance to relatives or friends, to establish charitable trusts, or to fund trusts as an estate planning tool to minimize estate taxes.

CFA Level I - Reading 50

Markowitz assumptions:

• Returns distribution. Investors look at each investment opportunity as a probability distribution of expected returns over a given horizon.
• Utility maximization. Investors behave such that they maximize their expected utility over a given investment horizon, and their indifference curves exhibit diminishing marginal utility of wealth.
• Risk is variability. Investors measure risk as the variance of expected returns.
• Risk/return. Investors make all investment decisions by considering only the risk and return of an investment opportunity. This means that their utility (indifference) curves are a function of the expected return and variance of the returns distribution they envision for each investment.
• Risk aversion. Given two investments with equal expected returns, investors prefer the one with the lowest risk. Likewise, given two investments with equal risk, investors prefer the one with the greatest expected return

Covariance is a measure of the degree to which 2 variables move together relative to their individual mean values over time.

The magnitude of the covariance depends on the variances of the individual return series, as well as on the relationship between the series.

The zero correlation does not mean the 2 assets are independent.
If the correlation coefficient were -1, a zero variance portfolio could be constructed.

Covariance can be standardized by dividing by the product of the standard deviations of the two securities being compared. This standardized measure of co-movement is called correlation.



Adding a new security to a portfolio has 2 effects on the portfolio's std. deviation: 1. the asset's own variance of returns. 2. the covariance between the returns of this new asset and the returns of every other asset.

An important factor to consider when adding an investment to a portfolio is not the new security's own variance but its average covariance with all the other investments in the portfolio.

A portfolio is efficient if it (1) maximizes return for a given risk level, or (2) minimizes risk for a given return target. The efficient frontier represents the set of portfolios that will give you the highest return at each level of risk (or, alternatively, the lowest risk for each level of return).

The efficient frontier line bends backwards due to less than perfect correlation between assets.

The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier. The optimal portfolio is the portfolio that gives the investor the greatest possible utility.