STUDY SESSION 1 ETHICAL AND PROFESSIONAL STANDARDS T he readings in this study session present a framework for ethical conduct in the investment profession by focusing on the CFA Institute Code of Ethics and Standards of Professional Conduct as well as the Global Investment Performance Standards (GIPS®). The principles and guidance presented in the CFA Institute Standards of Practice Handbook (SOPH) form the basis for the CFA Institute self-regulatory program to maintain the highest professional standards among investment practitioners. Guidance” in the SOPH addresses the practical application of the Code and Standards. The guidance reviews the purpose and scope of each standard, presents recommended procedures for compliance, and provides examples of the standard in practice. The GIPS facilitate efficient comparison of investment performance among investment managers and across country borders by prescribing methodology and standards that are consistent with a clear and honest presentation of returns. Having a global standard for reporting investment performance minimizes the potential for ambiguous or misleading presentations.
READING ASSIGNMENTS Reading 1 Reading 2 Reading 3 Reading 4 Code of Ethics and Standards of Professional Conduct Standards of Practice Handbook, Ninth Edition Guidance for Standards I–VII Standards of Practice Handbook, Ninth Edition Introduction to the Global Investment Performance Standards (GIPS®) Global Investment Performance Standards (GIPS®) www. cfainstitute. org/toolkit—Your online preparation resource Study Session 1 LEARNING OUTCOMES Reading 1: Code of Ethics and Standards of Professional Conduct The candidate should be able to: a. escribe the structure of the CFA Institute Professional Conduct Program and the process for the enforcement of the Code and Standards; b. state the six components of the Code of Ethics and the seven Standards of Professional Conduct; c. explain the ethical responsibilities required by the Code and Standards, including the multiple subsections of each Standard. Reading 2: Guidance for Standards I–VII The candidate should be able to: a. demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to situations involving issues of professional integrity; b. istinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards; c. recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct. Reading 3: Introduction to the Global Investment Performance Standards (GIPS®) The candidate should be able to: a. explain why the GIPS standards were created, what parties the GIPS standards apply to, and who is served by the standards; b. explain the construction and purpose of composites in performance reporting; c. xplain the requirements for verification of compliance with GIPS standards. Reading 4: Global Investment Performance Standards (GIPS®) The candidate should be able to: a. describe the key characteristics of the GIPS standards and the fundamentals of compliance; b. describe the scope of the GIPS standards with respect to an investment firm’s definition and historical performance record; c. explain how the GIPS standards are implemented in countries with existing standards for performance reporting and describe the appropriate response when the GIPS standards and local regulations conflict; d. haracterize the eight major sections of the GIPS standards. www. cfainstitute. org/toolkit—Your online preparation resource STUDY SESSION 2 QUANTITATIVE METHODS: Basic Concepts T his introductory study session presents the fundamentals of some of those quantitative techniques that are essential in almost any type of financial analysis, and which will be used throughout the remainder of the CFA curriculum. This session introduces two main building blocks of the quantitative analytical tool kit: the time value of money and statistics and probability theory.
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The time value of money concept is one of the main principles of financial valuation. The calculations based on this principle (e. g. , present value, future value, and internal rate of return) are the basic tools used to support corporate finance decisions and estimate the fair value of fixed income, equity, or any other type of security or investment. Similarly, the basic concepts of statistics and probability theory constitute the essential tools used in describing the main statistical properties of a population and understanding and applying various probability concepts in practice.
READING ASSIGNMENTS Reading 5 The Time Value of Money Quantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA Discounted Cash Flow Applications Quantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA Statistical Concepts and Market Returns Quantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E.
Runkle, CFA Probability Concepts Quantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA Reading 6 Reading 7 Reading 8 www. cfainstitute. org/toolkit—Your online preparation resource Study Session 2 LEARNING OUTCOMES Reading 5: The Time Value of Money The candidate should be able to: a. interpret interest rates as required rate of return, discount rate, or opportunity cost; b. explain an interest rate as the sum of a real risk-free rate, expected inflation, and premiums that compensate investors for distinct types of risk; c. alculate and interpret the effective annual rate, given the stated annual interest rate and the frequency of compounding; d. solve time value of money problems when compounding periods are other than annual; e. calculate and interpret the future value (FV) and present value (PV) of a single sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows; f. draw a time line and solve time value of money applications (for example, mortgages and savings for college tuition or retirement).
Reading 6: Discounted Cash Flow Applications The candidate should be able to: a. calculate and interpret the net present value (NPV) and the internal rate of return (IRR) of an investment, contrast the NPV rule to the IRR rule, and identify problems associated with the IRR rule; b. define, calculate, and interpret a holding period return (total return); c. calculate, interpret, and distinguish between the money-weighted and timeweighted rates of return of a portfolio and appraise the performance of portfolios based on these measures; d. alculate and interpret the bank discount yield, holding period yield, effective annual yield, and money market yield for a U. S. Treasury bill; e. convert among holding period yields, money market yields, effective annual yields, and bond equivalent yields. Reading 7: Statistical Concepts and Market Returns The candidate should be able to: a. differentiate between descriptive statistics and inferential statistics, between a population and a sample, and among the types of measurement scales; b. explain a parameter, a sample statistic, and a frequency distribution; c. alculate and interpret relative frequencies and cumulative relative frequencies, given a frequency distribution; d. describe the properties of a data set presented as a histogram or a frequency polygon; e. define, calculate, and interpret measures of central tendency, including the population mean, sample mean, arithmetic mean, weighted average or mean (including a portfolio return viewed as a weighted mean), geometric mean, harmonic mean, median, and mode; www. cfainstitute. org/toolkit—Your online preparation resource Study Session 2 f. describe, calculate, and interpret quartiles, quintiles, deciles, and percentiles; g. efine, calculate, and interpret 1) a range and a mean absolute deviation and 2) the variance and standard deviation of a population and of a sample; h. calculate and interpret the proportion of observations falling within a specified number of standard deviations of the mean using Chebyshev’s inequality; i. define, calculate, and interpret the coefficient of variation and the Sharpe ratio; j. define and interpret skewness, explain the meaning of a positively or negatively skewed return distribution, and describe the relative locations of the mean, median, and mode for a nonsymmetrical distribution; k. efine and interpret measures of sample skewness and kurtosis; l. discuss the use of arithmetic mean or geometric mean when determining investment returns. Reading 8: Probability Concepts The candidate should be able to: a. define a random variable, an outcome, an event, mutually exclusive events, and exhaustive events; b. explain the two defining properties of probability and distinguish among empirical, subjective, and a priori probabilities; c. state the probability of an event in terms of odds for or against the event; d. distinguish between unconditional and conditional probabilities; e. efine and explain the multiplication, addition, and total probability rules; f. calculate and interpret 1) the joint probability of two events, 2) the probability that at least one of two events will occur, given the probability of each and the joint probability of the two events, and 3) a joint probability of any number of independent events; g. distinguish between dependent and independent events; h. calculate and interpret, using the total probability rule, an unconditional probability; i. explain the use of conditional expectation in investment applications; j. iagram an investment problem using a tree diagram; k. calculate and interpret covariance and correlation; l. calculate and interpret the expected value, variance, and standard deviation of a random variable and of returns on a portfolio; m. calculate and interpret covariance given a joint probability function; n. calculate and interpret an updated probability using Bayes’ formula; o. identify the most appropriate method to solve a particular counting problem and solve counting problems using the factorial, combination, and permutation notations. www. cfainstitute. org/toolkit—Your online preparation resource
STUDY SESSION 3 QUANTITATIVE METHODS: Application T his study session introduces some of the discrete and continuous probability distributions most commonly used to describe the behavior of random variables. Probability theory and calculations are widely applied in finance, for example, in the field of investment and project valuation and in financial risk management. Furthermore, this session teaches how to estimate different parameters (e. g. , mean and standard deviation) of a population if only a sample, rather than the whole population, can be observed. Hypothesis testing is a closely related topic.
This session presents the techniques that can be applied to accept or reject an assumed hypothesis (null hypothesis) about various parameters of a population. Finally, you will also learn about the fundamentals of technical analysis. It is important that analysts properly understand the assumptions and limitations when applying these tools as mis-specified models or improperly used tools can result in misleading conclusions. READING ASSIGNMENTS Reading 9 Common Probability Distributions Quantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W.
McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA Sampling and Estimation Quantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA Hypothesis Testing Quantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA Technical Analysis Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly, CFA and Keith C. Brown, CFA Reading 10 Reading 11 Reading 12 ww. cfainstitute. org/toolkit—Your online preparation resource Study Session 3 LEARNING OUTCOMES Reading 9: Common Probability Distributions The candidate should be able to: a. explain a probability distribution and distinguish between discrete and continuous random variables; b. describe the set of possible outcomes of a specified discrete random variable; c. interpret a probability function, a probability density function, and a cumulative distribution function; d. calculate and interpret probabilities for a random variable, given its cumulative distribution function; e. efine a discrete uniform random variable and a binomial random variable; f. calculate and interpret probabilities given the discrete uniform and the binomial distribution functions; g. construct a binomial tree to describe stock price movement; h. describe the continuous uniform distribution and calculate and interpret probabilities, given a continuous uniform probability distribution; i. explain the key properties of the normal distribution, distinguish between a univariate and a multivariate distribution, and explain the role of correlation in the multivariate normal distribution; j. etermine the probability that a normally distributed random variable lies inside a given confidence interval; k. define the standard normal distribution, explain how to standardize a random variable, and calculate and interpret probabilities using the standard normal distribution; l. define shortfall risk, calculate the safety-first ratio, and select an optimal portfolio using Roy’s safety-first criterion; m. explain the relationship between normal and lognormal distributions and why the lognormal distribution is used to model asset prices; n. istinguish between discretely and continuously compounded rates of return and calculate and interpret a continuously compounded rate of return, given a specific holding period return; o. explain Monte Carlo simulation and historical simulation and describe their major applications and limitations. Reading 10: Sampling and Estimation The candidate should be able to: a. define simple random sampling, sampling error, and a sampling distribution, and interpret sampling error; b. distinguish between simple random and stratified random sampling; c. istinguish between time-series and cross-sectional data; d. interpret the central limit theorem and describe its importance; e. calculate and interpret the standard error of the sample mean; f. distinguish between a point estimate and a confidence interval estimate of a population parameter; www. cfainstitute. org/toolkit—Your online preparation resource Study Session 3 g. identify and describe the desirable properties of an estimator; h. explain the construction of confidence intervals; i. describe the properties of
Student’s t-distribution and calculate and interpret its degrees of freedom; j. calculate and interpret a confidence interval for a population mean, given a normal distribution with 1) a known population variance, 2) an unknown population variance, or 3) an unknown variance and a large sample size; k. discuss the issues regarding selection of the appropriate sample size, data-mining bias, sample selection bias, survivorship bias, look-ahead bias, and time-period bias. Reading 11: Hypothesis Testing The candidate should be able to: a. efine a hypothesis, describe the steps of hypothesis testing, interpret and discuss the choice of the null hypothesis and alternative hypothesis, and distinguish between one-tailed and two-tailed tests of hypotheses; b. define and interpret a test statistic, a Type I and a Type II error, and a significance level, and explain how significance levels are used in hypothesis testing; c. define and interpret a decision rule and the power of a test, and explain the relation between confidence intervals and hypothesis tests; d. distinguish between a statistical result and an economically meaningful result; e. xplain and interpret the p-value as it relates to hypothesis testing; f. identify the appropriate test statistic and interpret the results for a hypothesis test concerning the population mean of both large and small samples when the population is normally or approximately distributed and the variance is 1) known or 2) unknown; g. identify the appropriate test statistic and interpret the results for a hypothesis test concerning the equality of the population means of two at least approximately normally distributed populations, based on independent random samples with 1) equal or 2) unequal assumed variances; h. dentify the appropriate test statistic and interpret the results for a hypothesis test concerning the mean difference of two normally distributed populations (paired comparisons test); i. identify the appropriate test statistic and interpret the results for a hypothesis test concerning 1) the variance of a normally distributed population, and 2) the equality of the variances of two normally distributed populations, based on two independent random samples; j. istinguish between parametric and nonparametric tests and describe the situations in which the use of nonparametric tests may be appropriate. Reading 12: Technical Analysis The candidate should be able to: a. explain the underlying assumptions of technical analysis; b. discuss the advantages of and challenges to technical analysis; c. list and describe examples of each major category of technical trading rules and indicators. www. cfainstitute. org/toolkit—Your online preparation resource STUDY SESSION 4 ECONOMICS: Microeconomic Analysis T is study session focuses on microeconomic concepts and how firms are affected by these concepts. One of the main concepts related to the equilibrium between demand and supply is elasticity, which measures the rate of changes on the equilibrium price level. A second key concept is efficiency, which is a measure of the firm’s “optimal” output given its cost and revenue functions. Understanding these concepts enables analysts to differentiate among various companies on an individual level and to determine their attractiveness for an investor. READING ASSIGNMENTS
Reading 13 Reading 14 Reading 15 Reading 16 Reading 17 Elasticity Economics, Eighth Edition, by Michael Parkin Efficiency and Equity Economics, Eighth Edition, by Michael Parkin Markets in Action Economics, Eighth Edition, by Michael Parkin Organizing Production Economics, Eighth Edition, by Michael Parkin Output and Costs Economics, Eighth Edition, by Michael Parkin LEARNING OUTCOMES Reading 13: Elasticity The candidate should be able to: a. calculate and interpret the elasticities of demand (price elasticity, cross elasticity, and income elasticity) and the elasticity of supply and discuss the factors that influence each measure; b. alculate elasticities on a straight-line demand curve, differentiate among elastic, inelastic, and unit elastic demand, and describe the relation between price elasticity of demand and total revenue. www. cfainstitute. org/toolkit—Your online preparation resource Study Session 4 Reading 14: Efficiency and Equity The candidate should be able to: a. explain the various means of markets to allocate resources, describe marginal benefit and marginal cost, and demonstrate why the efficient quantity occurs when marginal benefit equals marginal cost; b. istinguish between the price and the value of a product and explain the demand curve and consumer surplus; c. distinguish between the cost and the price of a product and explain the supply curve and producer surplus; d. discuss the relationship between consumer surplus, producer surplus, and equilibrium; e. explain 1) how efficient markets ensure optimal resource utilization and 2) the obstacles to efficiency and the resulting underproduction or overproduction, including the concept of deadweight loss; f. xplain the two groups of ideas about the fairness principle (utilitarianism and the symmetry principle) and discuss the relation between fairness and efficiency. Reading 15: Markets in Action The candidate should be able to: a. explain market equilibrium, distinguish between long-term and short-term effects of outside shocks, and describe the effects of rent ceilings on the existence of black markets in the housing sector and on the market’s efficiency; b. describe labor market equilibrium and explain the effects and inefficiencies of a minimum wage above the equilibrium wage; c. xplain the impact of taxes on supply, demand, and market equilibrium, and describe tax incidence and its relation to demand and supply elasticity; d. discuss the impact of subsidies, quotas, and markets for illegal goods on demand, supply, and market equilibrium. Reading 16: Organizing Production The candidate should be able to: a. explain the types of opportunity cost and their relation to economic profit, and calculate economic profit; b. discuss a company’s constraints and their impact on achievability of maximum profit; c. ifferentiate between technological efficiency and economic efficiency and calculate economic efficiency of various companies under different scenarios; d. explain command systems and incentive systems to organize production, the principal-agent problem, and measures a firm uses to reduce the principal-agent problem; e. describe the different types of business organization and the advantages and disadvantages of each; f. calculate and interpret the four-firm concentration ratio and the HerfindahlHirschman Index and discuss the limitations of concentration measures; g. xplain why companies are often more efficient than markets in coordinating economic activity. www. cfainstitute. org/toolkit—Your online preparation resource Study Session 4 Reading 17: Output and Costs The candidate should be able to: a. differentiate between short-run and long-run decision time frames; b. describe and explain the relations among total product of labor, marginal product of labor, and average product of labor, and describe increasing and decreasing marginal returns; c. istinguish among total cost (including both fixed cost and variable cost), marginal cost, and average cost, and explain the relations among the various cost curves; d. explain the company’s production function, its properties of diminishing returns and diminishing marginal product of capital, the relation between short-run and long-run costs, and how economies and diseconomies of scale affect long-run costs. www. cfainstitute. org/toolkit—Your online preparation resource STUDY SESSION 5 ECONOMICS: Market Structure and Macroeconomic Analysis
T his study session first compares and contrasts the different market structures in which companies operate. The market environment influences the price a company can demand for its goods or services. The most important of these market forms are monopoly and perfect competition, although monopolistic competition and oligopoly are also covered. The study session then introduces the macroeconomic concepts that have an effect on all companies in the same environment, be it a country, a group of related countries, or a particular industry.
The study session concludes by describing how an economy’s aggregate supply and aggregate demand are determined. READING ASSIGNMENTS Reading 18 Reading 19 Reading 20 Reading 21 Reading 22 Reading 23 Perfect Competition Economics, Eighth Edition, by Michael Parkin Monopoly Economics, Eighth Edition, by Michael Parkin Monopolistic Competition and Oligopoly Economics, Eighth Edition, by Michael Parkin Markets for Factors of Production Economics, Eighth Edition, by Michael Parkin Monitoring Jobs and the Price Level Economics, Eighth Edition, by Michael Parkin Aggregate Supply and Aggregate Demand Economics, Eighth Edition, by Michael Parkin ww. cfainstitute. org/toolkit—Your online preparation resource Study Session 5 LEARNING OUTCOMES Reading 18: Perfect Competition The candidate should be able to: a. describe the characteristics of perfect competition, explain why companies in a perfectly competitive market are price takers, and differentiate between market and company demand curves; b. determine the profit maximizing (loss minimizing) output for a perfectly competitive company and explain marginal cost, marginal revenue, and economic profit and loss; c. escribe a perfectly competitive company’s short-run supply curve and explain the impact of changes in demand, entry and exit of companies, and changes in plant size on the long-run equilibrium; d. discuss how a permanent change in demand or changes in technology affect price, output, and economic profit. Reading 19: Monopoly The candidate should be able to: a. describe the characteristics of a monopoly, including factors that allow a monopoly to arise and monopoly price-setting strategies; b. xplain the relation between price, marginal revenue, and elasticity for a monopoly and determine a monopoly’s profit-maximizing price and quantity; c. explain price discrimination and why perfect price discrimination is efficient; d. explain how consumer and producer surplus are redistributed in a monopoly, including the occurrence of deadweight loss and rent seeking; e. explain the potential gains from monopoly and the regulation of a natural monopoly. Reading 20: Monopolistic Competition and Oligopoly The candidate should be able to: a. describe the characteristics of monopolistic competition and an oligopoly; b. etermine the profit-maximizing (loss-minimizing) output under monopolistic competition, explain why long-run economic profit under monopolistic competition is zero, and determine if monopolistic competition is efficient; c. explain the importance of innovation, product development, advertising, and branding under monopolistic competition; d. explain the kinked demand curve model and the dominant firm model and determine the profit-maximizing (loss-minimizing) output under each model; e. describe oligopoly games including the Prisoners’ Dilemma.
Reading 21: Markets for Factors of Production The candidate should be able to: a. explain why demand for the factors of production is called derived demand, differentiate between marginal revenue and marginal revenue product (MRP), and describe how the MRP determines the demand for labor and the wage rate; www. cfainstitute. org/toolkit—Your online preparation resource Study Session 5 b. describe the factors that cause changes in the demand for labor and the factors that determine the elasticity of the demand for labor; c. describe the factors determining the supply of labor, including the substitution and ncome effects, and discuss the factors related to changes in the supply of labor, including capital accumulation; d. describe the effects on wages of labor unions and of a monopsony and explain the possible consequences for a market that offers an efficient wage; e. differentiate between physical capital and financial capital and explain the relation between the demand for physical capital and the demand for financial capital; f. explain the factors that influence the demand and supply of capital; g. differentiate between renewable and nonrenewable natural resources and describe the supply curve for each; h. ifferentiate between economic rent and opportunity costs. Reading 22: Monitoring Jobs and the Price Level The candidate should be able to: a. define an unemployed person and interpret the main labor market indicators; b. define aggregate hours and real wage rates and explain their relation to gross domestic product (GDP); c. explain the types of unemployment, full employment, the natural rate of unemployment, and the relation between unemployment and real GDP; d. explain and calculate the consumer price index (CPI) and the inflation rate, describe the relation between the CPI and the inflation rate, and explain the main sources of CPI bias.
Reading 23: Aggregate Supply and Aggregate Demand The candidate should be able to: a. explain the factors that influence real GDP and long-run and short-run aggregate supply, explain movement along the long-run and short-run aggregate supply curves (LAS and SAS), and discuss the reasons for changes in potential GDP and aggregate supply; b. explain the components of and the factors that affect real GDP demand, describe the aggregate demand curve and why it slopes downward, and explain the factors that can change aggregate demand; c. ifferentiate between short-run and long-run macroeconomic equilibrium and explain how economic growth, inflation, and changes in aggregate demand and supply influence the macroeconomic equilibrium; d. compare and contrast the classical, Keynesian, and monetarist schools of macroeconomics. www. cfainstitute. org/toolkit—Your online preparation resource STUDY SESSION 6 ECONOMICS: Monetary and Fiscal Economics T his study session focuses on the monetary sector of an economy. It examines the functions of money and how it is created, highlighting the special role of the central bank within an economy.
Supply and demand for resources, such as labor and capital, and goods are strongly interrelated. This study session describes circumstances when this relationship may lead to inflation or unemployment and how these concepts relate to the business cycle. Finally, the goals and implications of fiscal and monetary policy are explored by examining some of the main models of macroeconomic theory (classical, Keynesian, and monetarist). READING ASSIGNMENTS Reading 24 Reading 25 Reading 26 Reading 27 Reading 28 Money, the Price Level, and Inflation Economics, Eighth Edition, by Michael Parkin U. S.
Inflation, Unemployment, and Business Cycles Economics, Eighth Edition, by Michael Parkin Fiscal Policy Economics, Eighth Edition, by Michael Parkin Monetary Policy Economics, Eighth Edition, by Michael Parkin An Overview of Central Banks International Economic Indicators and Central Banks, by Anne Dolganos Picker LEARNING OUTCOMES Reading 24: Money, the Price Level, and Inflation The candidate should be able to: a. explain the functions of money; b. describe the components of the M1 and M2 measures of money and discuss why checks and credit cards are not counted as money; www. cfainstitute. rg/toolkit—Your online preparation resource Study Session 6 c. describe the economic functions of and differentiate among the various depository institutions and explain the impact of financial regulation, deregulation, and innovation; d. explain the goals of the U. S. Federal Reserve (Fed) in conducting monetary policy and how the Fed uses its policy tools to control the quantity of money, and describe the assets and liabilities on the Fed’s balance sheet; e. discuss the creation of money, including the role played by excess reserves, and calculate the amount of loans a bank can generate, given new deposits; f. escribe the monetary base and explain the relation among the monetary base, the money multiplier, and the quantity of money; g. explain the factors that influence the demand for money and describe the demand for money curve, including the effects of changes in real GDP and financial innovation; h. explain interest rate determination and the short-run and long-run effects of money on real GDP; i. discuss the quantity theory of money and its relation to aggregate supply and aggregate demand. Reading 25: U. S. Inflation, Unemployment, and Business Cycles The candidate should be able to: a. ifferentiate between inflation and the price level; b. describe and distinguish among the factors resulting in demand-pull and costpush inflation and describe the evolution of demand-pull and cost-push inflationary processes; c. explain the costs of anticipated inflation; d. explain the relation among inflation, nominal interest rates, and the demand and supply of money; e. explain the impact of inflation on unemployment and describe the short-run and long-run Phillips curve, including the effect of changes in the natural rate of unemployment; f. explain how economic growth, inflation, and unemployment affect the business cycle; g. escribe mainstream business cycle theory and real business cycle (RBC) theory and distinguish between them, including the role of productivity changes. Reading 26: Fiscal Policy The candidate should be able to: a. explain supply side effects on employment, potential GDP, and aggregate supply, including the income tax and taxes on expenditure, and describe the Laffer curve and its relation to supply side economics; b. discuss the sources of investment finance and the influence of fiscal policy on capital markets, including the crowding-out effect; c. discuss the generational ffects of fiscal policy, including generational accounting and generational imbalance; www. cfainstitute. org/toolkit—Your online preparation resource Study Session 6 d. discuss the use of fiscal policy to stabilize the economy, including the effects of the government expenditure multiplier, the tax multiplier, and the balanced budget multiplier; e. explain the limitations of discretionary fiscal policy and differentiate between discretionary fiscal policy and automatic stabilizers. Reading 27: Monetary Policy The candidate should be able to: a. discuss the goals of U. S. onetary policy and the Fed’s means for achieving the goals, including how the Fed operationalizes those goals; b. describe how the Fed conducts monetary policy and explain the Fed’s decisionmaking strategy, including an instrument rule, a targeting rule, open-market operations, and the market for reserves; c. discuss monetary policy’s transmission mechanism (chain of events) between changing the federal funds rate and achieving the ultimate monetary policy goal when fighting either inflation or recession, and explain loose links and time lags in the adjustment process; d. escribe alternative monetary policy strategies and explain why they have been rejected by the Fed. Reading 28: An Overview of Central Banks The candidate should be able to: a. identify the functions of a central bank; b. discuss monetary policy and the tools utilized by central banks to carry out monetary policy. www. cfainstitute. org/toolkit—Your online preparation resource STUDY SESSION 7 FINANCIAL REPORTING AND ANALYSIS: An Introduction T he readings in this study session discuss the general principles of the financial reporting system, underscoring the critical role of the analysis of financial reports in investment decision making.
The first reading introduces the range of information that an analyst may use in analyzing the financial performance of a company, including the principal financial statements (the income statement, balance sheet, statement of cash flows, and statement of changes in owners’ equity), notes to those statements, and management’s discussion and analysis of results. A general framework for addressing most financial statement analysis tasks is also presented. A company’s financial statements are the end-products of a process for recording the business transactions of the company.
The second reading illustrates this process, introducing such basic concepts as the accounting equation and accounting accruals. The presentation of financial information to the public by a company must conform to applicable financial reporting standards based on factors such as the jurisdiction in which the information is released. The final reading in this study explores the role of financial reporting standard-setting bodies worldwide and the International Financial Reporting Standards framework promulgated by one key body, the International Accounting Standards Board.
The movement towards worldwide convergence of financial reporting standards is also introduced. Note: New rulings and/or pronouncements issued after the publication of the readings in Study Sessions 7 through 10 in financial statement analysis may cause some of the information in these readings to become dated. Candidates are expected to be familiar with the overall analytical framework contained in the study session readings, as well as the implications of alternative accounting methods for financial analysis and valuation, as provided in the assigned readings.
For the purpose of Level I questions on financial statement analysis, when a ratio is defined and calculated differently in various texts, candidates should use the definitions given in the CFA Institute copyrighted readings by Robinson, et al. Variations in ratio definitions are part of the nature of practical financial analysis. www. cfainstitute. org/toolkit—Your online preparation resource Study Session 7 READING ASSIGNMENTS Reading 29 Financial Statement Analysis: An Introduction International Financial Statement Analysis, by Thomas R.
Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Financial Reporting Mechanics International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Financial Reporting Standards International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Reading 30 Reading 31 LEARNING OUTCOMES
Reading 29: Financial Statement Analysis: An Introduction The candidate should be able to: a. discuss the roles of financial reporting and financial statement analysis; b. discuss the role of key financial statements (income statement, balance sheet, statement of cash flows, and statement of changes in owners’ equity) in evaluating a company’s performance and financial position; c. discuss the importance of financial statement notes and supplementary information, including disclosures of accounting methods, estimates, and assumptions, and management’s discussion and analysis; d. iscuss the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls; e. identify and explain information sources other than annual financial statements and supplementary information that analysts use in financial statement analysis; f. describe the steps in the financial statement analysis framework. Reading 30: Financial Reporting Mechanics The candidate should be able to: a. explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements; b. xplain the accounting equation in its basic and expanded forms; c. explain the process of recording business transactions using an accounting system based on the accounting equations; d. explain the need for accruals and other adjustments in preparing financial statements; e. explain the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners’ equity; f. describe the flow of information in an accounting system; g. explain the use of the results of the accounting process in security analysis. ww. cfainstitute. org/toolkit—Your online preparation resource Study Session 7 Reading 31: Financial Reporting Standards The candidate should be able to: a. explain the objective of financial statements and the importance of reporting standards in security analysis and valuation; b. explain the role of standard-setting bodies, such as the International Accounting Standards Board and the U. S. Financial Accounting Standards Board, and regulatory authorities such as the International Organization of Securities Commissions, the U. K.
Financial Services Authority, and the U. S. Securities and Exchange Commission in establishing and enforcing financial reporting standards; c. discuss the ongoing barriers to developing one universally accepted set of financial reporting standards; d. describe the International Financial Reporting Standards (IFRS) framework, including the qualitative characteristics of financial statements, the required reporting elements, and the constraints and assumptions in preparing financial statements; e. explain the general requirements for financial statements; f. ompare and contrast key concepts of financial reporting standards under IFRS and alternative reporting systems, and discuss the implications for financial analysis of differing financial reporting systems; g. identify the characteristics of a coherent financial reporting framework and barriers to creating a coherent financial reporting network; h. discuss the importance of monitoring developments in financial reporting standards and of evaluating company disclosures of significant accounting policies. www. cfainstitute. org/toolkit—Your online preparation resource STUDY SESSION 8
FINANCIAL REPORTING AND ANALYSIS: The Income Statement, Balance Sheet, and Cash Flow Statement E ach reading in this study session focuses on one of the three major financial statements: the balance sheet, the income statement, and the statement of cash flows. For each financial statement, the chapter details its purpose, construction, pertinent ratios, and common-size analysis. Understanding these concepts allows a financial analyst to evaluate trends in performance for several measurement periods and to compare the performance of different companies during the same period(s).
Additional analyst tools, such as the earnings per share calculation, are also described. READING ASSIGNMENTS Reading 32 Understanding the Income Statement International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Understanding the Balance Sheet International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A.
Broihahn, CFA Understanding the Cash Flow Statement International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Financial Analysis Techniques International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Reading 33 Reading 34 Reading 35 www. cfainstitute. org/toolkit—Your online preparation resource Study Session 8 LEARNING OUTCOMES
Reading 32: Understanding the Income Statement The candidate should be able to: a. describe the components of the income statement, and construct an income statement using the alternative presentation formats of that statement; b. explain the general principles of revenue recognition and accrual accounting, demonstrate specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, and gross and net reporting of revenue), and discuss the implications of revenue recognition principles for financial analysis; c. iscuss the general principles of expense recognition, such as the matching principle, specific expense recognition applications (including depreciation of long-term assets and inventory methods), and the implications of expense recognition principles for financial analysis; d. demonstrate the appropriate method of depreciating long-term assets, accounting for inventory, or amortizing intangibles, based on facts that might influence the decision; e. distinguish between the operating and nonoperating components of the income statement; f. iscuss the financial reporting treatment and analysis of nonrecurring items (including discontinued operations, extraordinary items, and unusual or infrequent items) and changes in accounting standards; g. describe the components of earnings per share and calculate a company’s earnings per share (both basic and diluted earnings per share) for both a simple and complex capital structure; h. differentiate between dilutive and antidilutive securities, and discuss the implications of each for the earnings per share calculation; i. describe and calculate comprehensive income; j. tate the accounting classification for items that are excluded from the income statement but affect owners’ equity, and list the major types of items receiving that treatment. Reading 33: Understanding the Balance Sheet The candidate should be able to: a. illustrate and interpret the components of the balance sheet and discuss the uses of the balance sheet in financial analysis; b. describe the various formats of balance sheet presentation; c. explain how assets and liabilities arise from the accrual process; d. compare and contrast current and noncurrent assets and liabilities; e. explain the measurement bases (e. . , historical cost and fair value) of assets and liabilities, including current assets, current liabilities, tangible assets, and intangible assets; f. demonstrate the appropriate classifications and related accounting treatments for marketable and nonmarketable financial instruments held as assets or owed by the company as liabilities; www. cfainstitute. org/toolkit—Your online preparation resource Study Session 8 g. list and explain the components of owners’ equity; h. interpret balance sheets and statements of changes in equity. Reading 34: Understanding the Cash Flow Statement The candidate should be able to: a. ompare and contrast cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of these three categories, given a description of the items; b. describe how noncash investing and financing activities are reported; c. compare and contrast the key differences in cash flow statements prepared under international financial reporting standards and U. S. generally accepted accounting principles; d. demonstrate the difference between the direct and indirect methods of presenting cash from operating activities and explain the arguments in favor of each; e. emonstrate the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data; f. describe the process of converting a cash flow statement from the indirect to the direct method of presentation; g. analyze and interpret a cash flow statement using both total currency amounts and common-size cash flow statements; h. explain and calculate free cash flow to the firm, free cash flow to equity, and other cash flow ratios. Reading 35: Financial Analysis Techniques The candidate should be able to: a. valuate and compare companies using ratio analysis, common-size financial statements, and charts in financial analysis; b. describe the limitations of ratio analysis; c. describe the various techniques of common-size analysis and interpret the results of such analysis; d. calculate, classify, and interpret activity, liquidity, solvency, profitability, and valuation ratios; e. demonstrate how ratios are related and how to evaluate a company using a combination of different ratios; f. demonstrate the application of and interpret changes in the component parts of the DuPont analysis (the decomposition of return on equity); g. alculate and interpret the ratios used in equity analysis, credit analysis, and segment analysis; h. describe how ratio analysis and other techniques can be used to model and forecast earnings. www. cfainstitute. org/toolkit—Your online preparation resource STUDY SESSION 9 FINANCIAL REPORTING AND ANALYSIS: Inventories, Long-Term Assets, Deferred Taxes, and On- and Off-Balance Sheet Debt T he readings in this study session examine specific categories of assets and liabilities that are particularly susceptible to the impact of alternative accounting policies and estimates.
Analysts must understand the effects of alternative policies on financial statements and ratios and be able to execute appropriate adjustments to enhance comparability between companies. In addition, analysts must be alert to differences between a company’s reported financial statements and economic reality. The description and measurement of inventories require careful attention because the investment in inventories is frequently the largest current asset for merchandizing and manufacturing companies. For these companies, the measurement of inventory cost (i. e. , cost of goods sold) is a critical factor in determining gross rofit and other measures of company profitability. Long-term operating assets are often the largest category of assets on a company’s balance sheet. The analyst needs to scrutinize management’s choices with respect to recognizing expenses associated with the operating assets because of the potentially large impact such choices can have on reported earnings and the opportunities for financial statement manipulation during longer time periods. A company’s accounting policies (such as depreciation choices) can cause differences in taxes reported in financial statements and taxes reported on tax returns.
The reading “Income Taxes” discusses several issues that arise relating to deferred taxes. Both on- and off-balance sheet debt affect a company’s liquidity and solvency and have consequences for its long-term growth and viability. The notes of the financial statements must be carefully reviewed to ensure that all potential liabilities (e. g. , leasing arrangements and other contractual commitments) are www. cfainstitute. org/toolkit—Your online preparation resource Study Session 9 appropriately evaluated for their conformity to economic reality.
Adjustments to the financial statements may be required to achieve comparability when evaluating several companies and may also be required to improve credit and investment decision-making. READING ASSIGNMENTS Reading 36 Inventories International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Long-Lived Assets International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Income Taxes International Financial Statement Analysis, by Thomas R.
Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Long-Term Liabilities and Leases International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA Reading 37 Reading 38 Reading 39 LEARNING OUTCOMES Reading 36: Inventories The candidate should be able to: a. explain IFRS and U. S. GAAP rules for determining inventory cost, including which costs are capitalized and methods of allocating costs between cost of goods sold and inventory; b. iscuss how inventories are reported on the financial statements and how the lower of cost or net realizable value is used and applied; c. compute ending inventory balances and cost of goods sold using the FIFO, weighted average cost, and LIFO methods to account for product inventory and explain the relationship among and the usefulness of inventory and cost of goods sold data provided by the FIFO, weighted average cost, and LIFO methods when prices are 1) stable, 2) decreasing, or 3) increasing; d. discuss and calculate ratios useful for evaluating inventory management; e. nalyze the financial statements of companies using different inventory accounting methods by comparing and describing the effect of the different methods on cost of goods sold, inventory balances, and other financial statement items; f. compute and describe the effects of the choice of inventory method on profitability, liquidity, activity, and solvency ratios; g. calculate adjustments to reported financial statements related to inventory assumptions to aid in comparing and evaluating companies; www. cfainstitute. org/toolkit—Your online preparation resource Study Session 9 . discuss the reasons that a LIFO reserve might rise or decline during a given period and discuss the implications for financial analysis. Reading 37: Long-Lived Assets The candidate should be able to: a. explain the accounting standards related to the capitalization of expenditures as part of long-lived assets, including interest costs; b. compute and describe the effects of capitalizing versus expensing on net income, shareholders’ equity, cash flow from operations, and financial ratios, including the effect on the interest coverage ratio of capitalizing interest costs; c. xplain the circumstances in which software development costs and research and development costs are capitalized; d. identify the different depreciation methods for long-lived tangible assets, and discuss how the choice of method, useful lives, and salvage values affect a company’s financial statements, ratios, and taxes; e. discuss the use of fixed asset disclosures to compare companies’ average age of depreciable assets and calculate, using such disclosures, the average age and average depreciable life of fixed assets; f. escribe amortization of intangible assets with finite useful lives and the estimates that affect the amortization calculations; g. discuss the liability for closure, removal, and environmental effects of long-lived operating assets, and discuss the financial statement impact and ratio effects of that liability; h. discuss the impact of sales or exchanges of long-lived assets on financial statements; i. define impairment of long-lived tangible and intangible assets and explain what effect such impairment has on a company’s financial statements and ratios; j. alculate and describe both the initial and long-lived effects of asset revaluations on financial ratios. Reading 38: Income Taxes The candidate should be able to: a. explain the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense; b. explain how deferred tax liabilities and assets are created and the factors that determine how a company’s deferred tax liabilities and assets should be treated for the purposes of financial analysis; c. etermine the tax base of a company’s assets and liabilities; d. calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax liabilities, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate; e. evaluate the impact of tax rate changes on a company’s financial statements and ratios; f. distinguish between temporary and permanent items in pre-tax financial income and taxable income; www. cfainstitute. org/toolkit—Your online preparation resource
Study Session 9 g. discuss the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements; h. compare and contrast a company’s deferred tax items; i. analyze disclosures relating to deferred tax items and the effective tax rate reconciliation, and discuss how information included in these disclosures affects a company’s financial statements and financial ratios; j. identify the key provisions of and differences between income tax accounting under IFRS and U. S. GAAP.
Reading 39: Long-Term Liabilities and Leases The candidate should be able to: a. compute the effects of debt issuance and amortization of bond discounts and premiums on financial statements and ratios; b. explain the role of debt covenants in protecting creditors by restricting a company’s ability to invest, pay dividends, or make other operating and strategic decisions; c. describe the presentation of, and disclosures relating to, financing liabilities; d. determine the effects of changing interest rates on the market value of debt and on financial statements and ratios; e. escribe two types of debt with equity features (convertible debt and debt with warrants) and calculate the effect of issuance of such instruments on a company’s debt ratios; f. discuss the motivations for leasing assets instead of purchasing them and the incentives for reporting the leases as operating leases rather than finance leases; g. determine the effects of finance and operating leases on the financial statements and ratios of the lessees and lessors; h. distinguish between a sales-type lease and a direct financing lease, and determine the effects on the financial statements and ratios of the lessors; i. escribe the types and economic consequences of off-balance sheet financing and determine how take-or-pay contracts, throughput arrangements, and the sale of receivables affect financial statements and selected financial ratios. www. cfainstitute. org/toolkit—Your online preparation resource STUDY SESSION 10 FINANCIAL REPORTING AND ANALYSIS: Applications and International Standards Convergence T he readings in this study session discuss financial statement analysis applications and the international convergence of accounting standards.
The most frequently used tools and techniques to evaluate companies include common size analysis, cross-sectional analysis, trend analysis, and ratio analysis. Beyond mere knowledge of these tools, however, the analyst must recognize the implications of accounting choices on the quality of a company’s reported financial results. Then the analyst can apply these financial analysis techniques to major analyst tasks including the evaluation of past and future financial performance, credit risk, and the screening of potential equity investments.
The readings also discuss analyst adjustments to reported financials. Such adjustments are often needed to put companies’ reported results on a comparable basis. This study session concludes with a reading on convergence of international and U. S. accounting standards. Although there has been much progress in harmonizing accounting standards globally, as this reading discusses, significant variations still exist among generally accepted accounting principles from one country to another. www. cfainstitute. org/toolkit—Your online preparation resource Study Session 10 READING ASSIGNMENTS
Reading 40 Financial Reporting Quality: Red Flags and Accounting Warning Signs Commercial Lending Review, by Thomas R. Robinson, CFA and Paul Munter Accounting Shenanigans on the Cash Flow Statement The CPA Journal, by Mark A. Siegel Financial Statement Analysis: Applications International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA International Standards Convergence International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R.
Elaine Henry, CFA, and Michael A. Broihahn, CFA Reading 41 Reading 42 Reading 43 LEARNING OUTCOMES Reading 40: Financial Reporting Quality: Red Flags and Accounting Warning Signs The candidate should be able to: a. describe incentives that might induce a company’s management to overreport or underreport earnings; b. describe activities that will result in a low quality of earnings; c. describe the “fraud triangle”; d. describe the risk factors that may lead to fraudulent accounting related to 1) incentives and pressures, 2) opportunities, and 3) attitudes and rationalizations; e. escribe common accounting warning signs and methods for detecting each; f. describe the accounting warning signs related to the Enron accounting scandal; g. describe the accounting warning signs related to the Sunbeam accounting scandal. Reading 41: Accounting Shenanigans on the Cash Flow Statement The candidate should be able to analyze and discuss the following ways to manipulate the cash flow statement: stretching out payables, financing of payables, securitization of receivables, and using stock buybacks to offset dilution of earnings.
Reading 42: Financial Statement Analysis: Applications The candidate should be able to: a. evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance; www. cfainstitute. org/toolkit—Your online preparation resource Study Session 10 b. prepare a basic projection of a company’s future net income and cash flow; c. describe the role of financial statement analysis in assessing the credit quality of a potential debt investment; d. discuss the use of financial statement analysis in screening for potential equity investments; e. etermine and justify appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company. Reading 43: International Standards Convergence The candidate should be able to: a. identify and explain the major international accounting standards for each asset and liability category on the balance sheet and the key differences from U. S. generally accepted accounting principles (GAAP); b. identify and explain the major international accounting standards for major revenue and expense categories on the income statement and the key differences from U. S. GAAP; c. dentify and explain the major differences between international and U. S. GAAP accounting standards concerning the treatment of interest and dividends on the statement of cash flows; d. interpret the effect of differences between international and U. S. GAAP accounting standards on the balance sheet, income statement, and the statement of changes in equity for some commonly used financial ratios. www. cfainstitute. org/toolkit—Your online preparation resource STUDY SESSION 11 CORPORATE FINANCE T his study session covers the principles that corporations use to make their investing and financing decisions.
Capital budgeting is the process of making decisions about which long-term projects the corporation should accept for investment and which it should reject. Both the expected return of a project and the financing cost should be taken into account. The cost of capital, or the rate of return required for a project, must be developed using economically sound methods. Corporate managers are also concerned with shorter-term liquidity and solvency and use financial statements to evaluate performance as well as to develop and communicate future plans.
The final reading in this study session is on corporate governance practices, which can expose the firm to a heightened risk of ethical lapses. Although these practices may not be inherently unethical, they create the potential for conflicts of interest to develop between shareholders and managers, and the extent of that conflict affects the company’s valuation. READING ASSIGNMENTS Reading 44 Reading 45 Reading 46 Capital Budgeting by John D. Stowe, CFA and Jacques R. Gagne, CFA Cost of Capital by Yves Courtois, CFA, Gene C. Lai, and Pamela P.
Peterson, CFA Working Capital Management by Edgar A. Norton, Jr. , CFA, Kenneth L. Parkinson, and Pamela P. Peterson, CFA Financial Statement Analysis by Pamela P. Peterson, CFA The Corporate Governance of Listed Companies: A Manual for Investors Reading 47 Reading 48 www. cfainstitute. org/toolkit—Your online preparation resource Study Session 11 LEARNING OUTCOMES Reading 44: Capital Budgeting The candidate should be able to: a. explain the capital budgeting process, including the typical steps of the process, and distinguish among the various categories of capital projects; b. iscuss the basic principles of capital budgeting, including the choice of the proper cash flows; c. explain how the following project interactions affect the evaluation of a capital project: 1) independent versus mutually exclusive projects, 2) project sequencing, and 3) unlimited funds versus capital rationing; d. calculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI); e. xplain the NPV profile, compare and contrast the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods; f. describe and account for the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock price. Reading 45: Cost of Capital The candidate should be able to: a. calculate and interpret the weighted average cost of capital (WACC) of a company; b. describe how taxes affect the cost of capital from different capital sources; c. escribe alternative methods of calculating the weights used in the WACC, including the use of the company’s target capital structure; d. explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget; e. explain the marginal cost of capital’s role in determining the net present value of a project; f. calculate and interpret the cost of fixed rate