Series 65/66 Review Analytics and Calculation Concepts

Series 65/66 Review Analytics and Calculation Concepts

Series 65/66 Review Analytics and Calculation Concepts 2 © Knopman Marks Financial Training Version: 2020 V5_2 1 3 Instructor and Support Your Instructors Name: Marcia Larson [email protected] Name:[email protected] Dave Meshkov [email protected] * * * Admin Questions (non-content) Email: [email protected] Phone: 212-626-6899 4 © Knopman Marks Financial Training Version: 2020 V5_2 2 Analytics Topics for Review # of Q - 65 Relatively few calculations, but enough to matter Conceptual calculation require knowledge of how to calculate Today’s Review Analytic Methods Financial Reporting Returns Portfolio Performance 5 Beta Beta measures the volatility of a particular equity security versus the market as a whole Beta of 1.00 tracks market Price not impacted by market fluctuation – beta of 0 91-day T-bill Positive beta Beta of 1.2 Beta of .8 Negative beta Investment moves in opposite direction 6 © Knopman Marks Financial Training Version: 2020 V5_2 3 Alpha Alpha measures how much realized return varies from required portfolio return Alpha of 1: outperforms by 1% Alpha of -1: underperforms by -1% When alpha is positive, the stock is undervalued and when alpha is negative, the stock is overvalued. 7 Risk-Return Measures Question Julian and Jane are discussing risk-return measures. Julian states that "beta is used when looking at the performance of a fund or portfolio and refers to the extent of any outperformance against its benchmark." Jane disagrees and says that "outperformance of a fund or portfolio is actually measured by standard deviation." Which of the following statement is correct? A. Only Julian is correct. B. Both are incorrect. C. Only Jane is correct. D. Both Julian and Jane are correct. © Knopman Marks Financial Training Version: 2020 V5_2 4 Risk-Return Measures Question Explanation Both Julian and Jane are incorrect. It is alpha, not beta, that is used when looking at the performance of a fund or portfolio. Alpha refers to the extent of any outperformance of a portfolio against its benchmark. Standard deviation is used for measuring volatility, not performance. Standard deviation: Compares to average returns Relates to “systematic” risk – not “unsystematic” risk Alpha Calculation Practice Alpha Equation Alpha = (Portfolio Return − Risk-Free Rate) − [Beta × (Market Return − Risk-Free Rate)] Exclude risk-free rate if not given Portfolio Risk-Free Beta MarketFree Rate)] Alpha × 12% N/A .5 8% (12%) − [0.5 (8%)] = (12)–(4) = 8 17% N/A 2 12% (17%) − [2 × (12%)] = (17)–(24) = (−7) 10% 2% 1 7% (10% − 2%) − [1 × (7%–2%)] = (8)–(5) = 3 10 © Knopman Marks Financial Training Version: 2020 V5_2 5 Alpha Calculation Question An investment adviser representative is looking for a suitable investment for a client. The IAR wishes to find something that will offer an attractive return commensurate with its systematic risk. The choices have been narrowed to Security C and Security L, and the selection will be based on alpha. C has a beta of 1.0 and earned 13%, while L has a beta of 0.8 and earned 10.1%. The alpha of Security L is A. −2.9 B. +2.9 C. −0.3 D. +0.3 Alpha Calculation Question Explanation Alpha = (Portfolio Return − Risk-Free Rate) − [Beta × (Market Return − Risk- Free Rate)] - Calculating alpha for Security L requires market return (13%). - No risk free rate is given Security L’s Alpha: 10.1 – [.8 × (13)] 10.1 – 10.4 = -.3 Which portfolio should the IAR recommend? © Knopman Marks Financial Training Version: 2020 V5_2 6 Sharpe Ratio Excess return compared to total risk (not unsystematic risk) Risk-adjusted return The higher the Sharpe ratio, the better the returns relative to the risk Expected vs. Real Return Expected Return Real Return (Inflation Adjusted) Subtract the risk-free rate Always subtract inflation rate from actual performance Measured by CPI Which of the following has the highest real return? A) A bond that yields 6% when inflation is 4% B) A bond that yields 5% when inflation is 1% C) A bond that yields 10% when inflation is 7% D) A bond that yields 8% when inflation is 5%. 14 © Knopman Marks Financial Training Version: 2020 V5_2 7 Expected vs. Real Return Explanation The calculation of real return requires subtraction of the inflation rate from the actual performance. B has the highest real return (5% – 1% = 4%). Rule of 72 Concepts Estimates how many years for an investment to double in value Divide 72 by the investment’s interest rate Rate = 6% Years to double = 12 Calculates the rate of return if number of years for investment to double is known Divide 72 by years to double Years to double = 8 Rate = 9% 16 © Knopman Marks Financial Training Version: 2020 V5_2 8 Rule of 72 Question 1 An investor places $10,000 into BCD common stock 12 years ago. Today, that stock has a market value of $20,000. Using the Rule of 72, the internal rate of return on BCD is closest to A) 6.8%. B) 8%. C) 6%. D) 5%. Rule of 72 Question 1 Explanation Using the Rule of 72, the rate of return can be calculated if the number of years for investment to double is known Divide 72 by years to double Years to double = 12 Rate = 72 / 12 = 6% © Knopman Marks Financial Training Version: 2020 V5_2 9 Rule of 72 Question 2 An investment of $5,000 made 10 years ago is now worth $20,000. Using the Rule of 72, what is the approximate compounded annual rate of return? A) 25% B) 7.2% C) 40% D) 14.4% Rule of 72 Question 2 Explanation This investment has quadrupled (doubled twice) in 10 years, so it actually doubled in 5 years. $5,000 $10,000 then $10,000 $20,000 5 years to double 5 years to double again Using the Rule of 72, 1) Divide 72 by 5 years for an approximate rate of 14.4%. © Knopman Marks Financial Training Version: 2020 V5_2 10 Net Present Value (NPV) The difference between the present value of the investment and its cost A dollar amount Calculated using Internal Rate of Return IRR is the discount rate that makes the future value equal to present value 10 years Costs $500 Today: FUTURE VALUE: PV (at 7.2%) = $500 NPV = 0 (indifferent) $1,000 (estimate) PV (at 6%) = $550 NPV = +$50 If 0: IRR = required return; highly efficient market If > 0: IRR > required return If < 0: IRR< required return Incorporates time value of money Net Present Value Question 1 An investor's required rate of return is 6%. If the internal rate of return of the investment offered is 5.75%, then the NPV is A) negative B) between 5.75% and 6% C) zero D) positive © Knopman Marks Financial Training Version: 2020 V5_2 11 Net Present Value Question 1 Explanation If the IRR is less than the required rate, the investment has a negative NPV. Investments with negative NPVs should typically be avoided. Net Present Value Question 2 An investment adviser is analyzing 4 bonds of similar quality for a client. Bond A has a coupon of 6%, matures in 12 years, and is currently priced at 50. Bond B has a coupon of 8%, matures in 9 years, and is currently priced at 50. Bond C has a coupon of 4%, matures in 18 years, and is priced at 45. Bond D has a coupon of 12%, matures in 6 years, and is priced at 50. Based on NPV, which of these bonds represents the better value? A) Bond A B) Bond B C) Bond C D) Bond D © Knopman Marks Financial Training Version: 2020 V5_2 12 Net Present Value Question 2 Explanation Without a financial calculator, you can estimate these outcomes using the Rule of 72. Divide 72 by the interest rate for the number of years to double Divide 72 by the number of years for the interest rate earned A bond with a positive NPV can be bought for less than its present value. Bond A, at 6%, takes 12 years to double, the same as time to maturity. So, PV of this bond should be approximately $500 (a quote of 50). Same is true for bonds B and D. Their PV should be approximately $500. (Because their price is the same as the PV, the NPV is zero). Bond C also has PV of about $500, but is the best value because it can be purchased at a discount. It has positive NPV (cost less than present value) so is the best buy. Working Capital and Liquidity Ratios Working Capital is money available to work Calculated from the balance sheet Current assets – current liabilities Working capital ratio is: Current assets Current liabilities Higher is better Acid Test (quick) ratio is more stringent; no inventory © Knopman Marks Financial Training Version: 2020 V5_2 13 Working Capital Question Which of the following items would be included in a current ratio computation? A) Cash, dividends payable, and shareholders’ equity B) Inventory, equipment, and cash C) Accounts receivable, inventory, and long-term debt D) Accounts payable, wages payable, and short-term debt Working Capital Question Explanation Current ratio is computed by dividing current assets by current liabilities. Current assets include cash, accounts receivable, and inventory. Current liabilities include accounts payable, wages payable, dividends payable, and short-term debt. Equipment is a fixed asset, long-term debt is not current, and shareholders' equity is net worth, so these are not in the computation. What current ratio position indicates more liquidity 5:1 or 2:1? © Knopman Marks Financial Training Version: 2020 V5_2 14 Price to Earnings Ratio An income statement calculation Subtract preferred dividends paid from net income, and then dividing the result by the number of shares outstanding How to calculate net income? Sales minus cost of goods sold = Operating Profit (Gross Profit) Then subtract operating expenses, depreciation, interest, taxex Also called operating income PE Ratio Question During the past year, the market price of Kapco common stock has increased from $47 to $50 per share.

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