Community Q&A
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How does a put option create a floor price for putable bonds?
A putable bond gives the holder the right to sell back to the issuer at a specified price, creating a price floor. When yields rise and the bond falls below the put price, the holder exercises the option, preventing further decline.
Can I use the residual income model when book value of equity is negative?
The residual income model can work with negative book value because future RI adds value on top of the negative anchor. When book value is negative, the equity charge becomes an addition to RI. However, the model becomes unstable and alternative approaches may be preferred.
How do I compute FCFE when the company is actively changing its capital structure?
When a company is deleveraging, net borrowing is negative, reducing FCFE significantly during the transition period. Model each year explicitly, then use the stable target capital structure for terminal value. Consider using FCFF/WACC when leverage is actively changing.
How do dividend reinvestment plans (DRIPs) work and what are their advantages and disadvantages?
A Dividend Reinvestment Plan automatically uses cash dividends to purchase additional shares of the issuing company. Some DRIPs offer shares at a discount. Key exam point: dividends are taxable even when reinvested, creating a tax liability without cash flow.
How do you calculate buyback yield and total payout yield for equity valuation?
Buyback yield measures the percentage of market capitalization returned through share repurchases. Total payout yield combines dividends and net buybacks. A company with a low dividend yield but significant buybacks may actually be returning substantial cash to shareholders.
What are measurement period adjustments in acquisition accounting?
The measurement period allows up to one year after an acquisition for the acquirer to refine provisional fair values of acquired assets and liabilities. Adjustments are made retrospectively, affecting goodwill and requiring restatement of comparative information. Only information about conditions existing at the acquisition date qualifies.
Can someone explain the cost recovery method and when it applies?
The cost recovery method is the most conservative revenue recognition approach where no profit is recognized until the seller has recovered the entire cost of the goods sold. Only after cumulative cash collections exceed total cost does any profit appear on the income statement.
How does comparative advantage work with actual numbers, and why does it lead to trade even when one country is better at everything?
Comparative advantage demonstrates that even when one country is more efficient at producing everything, both countries benefit from specializing in the good where their relative efficiency is greatest and trading.
Why does an option's time value decay accelerate as expiration approaches?
Time value decay accelerates as expiration approaches because option time value is proportional to the square root of time remaining, not time itself. This mathematical relationship means the last month before expiration destroys the most value.
Why does a callable bond have lower effective duration than an otherwise identical non-callable bond, and what is negative convexity?
Callable bonds behave very differently from plain vanilla bonds. The issuer has the right to redeem the bond at the call price when rates fall, creating an asymmetric payoff that truncates the upside.
How do I reconcile FCFE and FCFF — what is the bridge between them?
The bridge from FCFF to FCFE is: FCFE = FCFF - Interest x (1 - tax rate) + Net Borrowing. FCFF represents cash available to all capital providers, while FCFE removes debt-related flows to isolate cash available to equity holders only.
How does the 5-factor DuPont decomposition work? I understand the 3-factor version but the extended one confuses me.
The 5-factor DuPont model breaks ROE into tax burden, interest burden, EBIT margin, asset turnover, and equity multiplier. This lets you pinpoint whether a company's ROE comes from operational excellence or financial leverage.
How do I calculate when a margin call is triggered using the maintenance margin formula?
The margin call trigger price for a long position equals P_0 x (1 - Initial Margin) / (1 - Maintenance Margin). For a short position, the formula is P_0 x (1 + Initial Margin) / (1 + Maintenance Margin). Here is a step-by-step example with verification.
When and how do you impair an equity method investment, and is the write-down reversible?
Equity method investments are impaired when fair value drops below carrying amount and the decline is other-than-temporary. The key IFRS vs. US GAAP difference is that IFRS allows reversal of impairment losses while US GAAP does not.
What is the difference between a contract asset and a contract liability, and how do they appear on the balance sheet?
The distinction hinges on whether the right to payment is conditional or unconditional. A contract asset arises when the company has earned revenue but does not yet have an unconditional right to payment, while a contract liability exists when the customer has paid before the company has performed.
How does an IPS for a defined benefit pension plan differ from an individual IPS, and how do I assess pension risk tolerance?
A DB pension plan IPS uses the same RRTTLLU framework but focuses on funded status, sponsor strength, and workforce demographics rather than personal lifestyle. An overfunded plan with a strong sponsor and young workforce generally has above-average risk tolerance.
How do I calculate the after-tax cost of debt, and why does the tax shield matter for WACC?
The after-tax cost of debt equals YTM times (1 - tax rate), reflecting the tax deductibility of interest expense. Always use the yield to maturity rather than the coupon rate because YTM represents the current market cost of borrowing.
What are the grey areas around Standard II(A) Material Nonpublic Information, and how does the mosaic theory work?
Standard II(A) prohibits acting on information that is both material and nonpublic. The mosaic theory protects analysts who combine public information with individually non-material nonpublic pieces to form investment conclusions.
How do I interpret covariance in a portfolio context, and why is correlation often more useful?
Covariance captures the directional co-movement between two variables, but its magnitude is hard to interpret because it depends on the units of measurement. Correlation standardizes covariance to a -1 to +1 scale, making it immediately comparable across any pair of assets.
How do you convert between bank discount yield, holding period yield, money market yield, and bond equivalent yield?
The four money market yields differ in two dimensions: the denominator (face value for BDY vs. purchase price for the others) and the day count (360 vs. 365). Start by computing the holding period yield, then annualize with 360/t for money market yield or 365/t for bond equivalent yield. BDY is always the lowest.
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