FR&A - Financial Analysis Techniques

2:45 PM

Financial Analysis Techniques

Vertical Common Size Statements

• Balance sheet - everything as % of total assets
• Income statement - everything as % of sales
• Analysis of common size is good for spotting trends, but does not tell whole story

Horizontal Common Size Statements

• Base year = set everything to 1

Limitations of ratio analysis

• Not useful when viewed in isolation - need historical or peer context
• Different accounting treatments - especially in non-US firms
• Companies operating in multiple industries - difficult to find comparable ratios
• Determining a target is difficult - use a range of values

Liquidity Ratios

• current ratio = current assets / current liabilities
• 1 is the crucial number
• quick ratio = (cash + mktable securities + receivables) / current liabilities
• More conservative - excludes inventory
• Cash ratio - same as quick, but even excludes receivables - most conservative

Solvency Ratios - measure financial risk/leverage - higher=more risk

• long term D/E = total long term debt / total equity
• D/E = total debt / total equity
• Total Debt Ratio = total debt / total assets
• Financial Leverage = total assets / total equity

Common Size Income statement

• Effective tax rate is usually more meaningful than common size tax rate
• Profitability ratios
• Gross profit margin = gross profit / revenue
• Net profit margin = net income / revenue

Activity ratios

• receivables turnover = sales / average receivables
• collection period = days sales outstanding = 365 / receivables turnover
• Too high is bad for obv reasons
• Too low might mean tight credit policy is hampering sales
• inventory turnover = COGS / average inventory
• how many times you sell your stock in a year
• days inventory = 365 / inventory turnover
• payables turnover = purchases / average AP
• days payables = 365 / payables turnover
• Note: if quarterly, divide number of days in quarter by quarterly turnover ratio to get 'days' form of these numbers
• total asset turnover = revenue / avg total assets
• Too low, might have too much capital tied up in asset base
• Too high, might not have enough assets available for sale, or assets outdated
• fixed asset turnover = revenue / average net fixed assets
• Too low = using assets inefficiently
• Too high = equipment is obsolete
• working capital turnover = revenue / average working capital
• effectiveness of WC
• If you have very low working capital, might not be meaningful

Liquidity ratios

• Current, quick, and cash ratios (see above)
• Defensive Interval Ratio
• Number of days you can survive on current liquid assets
• DIR = (cash + marketable secs + receivables) / avg daily expenditures
• Take items from income statement - adjust for non-cash items
• Cash Conversion Cycle
• Length of time to turn inventory into cash
• CCC = days sales out + days of inventory - number of days payables
• Too high is bad

Solvency ratios

• Debt/capital, debt/assets, financial leverage (see above)
• Coverage ratios
• interest coverage = EBIT / interest payments
• fixed charge coverage = (EBIT + lease pmts) / (interest pmts + lease pmts)
• Important for airlines

Profitability ratios

• Net profit margin = net income / revenue
• Note: net income is before dividends, and total capital = debt + eq (both common and preferred)
• EBIT margin - be sure to consider gains/losses (nonoperating items in EBIT)
• Pretax Margin = EBT / revenue
• ROA = net income / avg total assets
• Misleading tho - interest excluded from net income but assets includes debt
• Alternative: ROA = (net income + interest exp * (1-t)) / average total assets
• Operating ROA = operating income / avg total assets
• Return on Total Capital = EBIT / average total capital
• ROE = net income / average total equity
• This includes both preferred and common stock
• Return on Common Equity = (net income - preferred dividends) / average common equity

Dupont Analysis - original 3 part approach

• Start with ROE = net income / equity
• Multiply by revenue/revenue and rearrange to get:
• ROE = (net income / revenue) * (revenue / equity)
• Multiply by assets/assets and rearrange again to get:
• ROE = (net income / revenue) * (revenue / assets) * (assets / equity)
• that is ROE = net profit margin * asset turnover * leverage

Dupont Analysis - 5 part approach

• Breaks net profit margin down even further
• ROE = (net income/EBIT) * (EBT/EBIT) * (EBIT/Revenue) * (Rev / assets) * (assets / equity)
• That is, ROE = tax burden * interest burden * EBIT margin * asset turnover * leverage
• This shows that increasing leverage does not necessarily increase ROE
• Interest burden rises
• Higher taxes always decrease ROE

Equity analysis

• PE ratio, price to cash flow, price to sales, price to book - all covered later
• Per share - EPS
• Diluted EPS - what if analysis
• Cash Flow per Share, EBIT per share, EBITDA per share
• Per share prices cannot be compared across companies

Dividends

• Proportion of earnings reinvested is called retention rate = 1 - dividend payout ratio
• Sustainable Growth Rate
• g = retention rate * ROE

Net income or sales per employee often used in service/consulting companies

Growth in same store sales and sales / sq foot are common in retail industry

Business risk - coefficients of variation

• CV sales = standard deviation / mean
• CV op income = sdev / mean
• Same for net income
• Can compare across firms, or within a firm across time

Financials

• Capital Adequacy = risk / equity capital
• Value at risk = dollar size of loss a firm will exceed only some % of time, over a given time
• Minimum reserve requirements - liquid asset requirements = liquid assets / certain liabilities
• Net Interest Margin = interest income / interest earning assets

Credit analysis

• Similar to those used before
• Altman Z-score - useful in predicting bankruptcies (low = high prob of failure)

Segment Analysis

• Segment accounts for 10% or more of revenue or assets
• Distinguishable from company's other lines of business in terms of risk/return characteristics
• Can be geographic too
• GAAP and IFRS both require segment reporting but standards for segments are lower
• Can be useful for forecasting

End

4:00 pm

1.25 hrs

FR&A - Cash Flow Statement

12:45 pm

Understanding the Cash Flow Statement

Net income is not the same thing as cash earnings

Investing activities - noncurrent assets
Financing - longterm liabilities and equity

Trading securities falls under operating cash flows, not investing

Acquisition of debt/equity instruments is listed under investing, but the income is reported as operating income.

Similarly, amounts borrowed fall under financing, but the interest expense is an operating activity.

Noncash items (e.g. financed acquisition of land, debt/equity exchanges) do not hit CF statement

• Must be disclosed in a footnote or supplementary schedule
• Analysts must be aware of these and their impact

US GAAP, dividends paid are financing, interest paid is operating.  Both int and dividends received are operating income.

IFRS allows more flex in accounting for dividends and interest payments

• Div and int received, can be either operating OR investing
• Div and int paid can be either operating OR financing

Tax calc is also different

• US, taxes are all reported in operating
• IFRS, also in operating UNLESS expense is associated w investing or financing transactions
• Ex, you sell land for $1 mm.  Taxes are $160,000.  
• US, you record cash from investing as $1 mm and cash for taxes in operating at $(160,000).  
• IFRS, you can just record $840,000 in investing

Both indirect and direct are permissible under US and IFRS but direct is encouraged

• Direct - convert each line of income statement into cash terms
• Indirect - start with net income
• Convert net income to operating cash flow
• Make adjustments for transactions that affect net income but not cash
• This can include nonoperating gains/losses
• Direct provides more info - operating cash receipts/pmts
• Main advantage of indirect is focus on differences b/w net income and op cash flow

Disclosure - under US GAAP, if you use direct, you must also show indirect.  Not required by IFRS.

When using direct method, ignore depreciation information - it is a noncash charge - common CFA trick

Direct method notes

• If assets were sold during period must account for this when calcing cash paid for a new asset
• Cash paid = ending assets - beginning assets + cost of old assets sold
• If calculating cash from asset sold, add in any gain/loss on the sale
• Interest paid is technically a cash flow to creditors but falls under operating cash flow
• Financing cash flow:
• Net cash from creditors = new borrowings - principal repaid
• PLUS
• Net cash from shareholders = new equity issued - share repurchases - cash dividends
• Total cash flow = CFO + CFI + CFF = change in cash from one balance sheet to next

Indirect method notes

• Subtract gains from sale on land from Net Income - this goes to investing cash flow

Converting from Indirect to Direct

• Only difference is presentation of CFO section
• Key is to adjust each income statement item for its corresponding balance sheet accounts and to eliminate noncash/nonoperating transactions
• Cash collections
• Start with net sales
• Subtract increase in AR and vv
• Add increase in unearned revenue and vv
• Cash payments to suppliers
• Start with COGS
• If D&A included, add back
• Reduce for increase in AP and vv
• Add for increase in inventory and vv
• Subtract any writeoff that occurred - it's not a real expense
• Same principal for taxes
• Cash operating expenses
• Start with SG&A
• Adjust for prepaid expenses

An increase in assets/decrease in liabilities is a use of cash

A decrease in assets/increase in liabilities is a source of cash

Analyzing cash flow statements

• Examine major sources and uses of cash.  These change over the company life cycle.
• Over long term, must be able to cover capex and provide return to debt/equity holders
• Operating cash flow
• Where does cash come from?  NWC adjustments are not a sustainable source
• Stable relation b/w operating cash flow and net income is an indication of quality of earnings
• Earnings > cash flow may indicate aggressive accounting.  Variability is also important.
• Investing cash flow
• Increasing capex usually a sign of growth
• Delaying capex or selling just to generate liquidity is not good - requires future payments
• Generally want to make operating cash flow that covers capex
• Financing cash flow
• Is company getting cash from debt or equity
• Is it repaying debt, reacquiring stock, or paying dividends

Common size cash flow statement

• Express each as a percent of sales OR
• Express each inflow as % of total inflows and each outflow as % of total outflows

Free Cash Flow to Firm - cash available to all investors, both debt and equity

• FCFF = Net Income + D&A + Interest * (1-tax) - CapEx - Working Capital investment
• Can also calc from operating cash flow:
• FCFF = CFO + Interest * (1-tax) - CapEx
• This already accounts for noncash and WC impacts
• IFRS - don't need to include interest expense that falls under financing section
• Also, note that IFRS can report dividends paid as operating - so add these back too (goal is to cal cash available to shareholders)

Free Cash Flow to Equity - cash available to common shareholders

• FCFE = CFO - CapEx + net borrowing (debt issued - debt repaid)
• IFRS need to add back dividends if they've been taken out of CFO

Ratios

• Cash Flow to Revenue = CFO / net revenue
• CFO generated per dollar of revenue
• Cash return on assets = CFO / average total assets
• Cash Return on Equity = CFO / average total equity
• Cash to Income = CFO / operating income
• Ability to generate cash from operations
• Cash Flow per Share = (CFO - preferred dividends) / wtd avg # common shares

Coverage Ratios

• Debt coverage = CFO / total debt
• Interest coverage = (CFO + interest paid + taxes paid) / interest paid
• Reinvestment = CFO / cash paid for LT assets
• Measures ability to buy assets with OCF
• Debt payment = CFO / cash long-term debt repayment
• Dividend payment = CFO / dividends paid
• Investing and Financing = CFO / cash outflows from investing and financing activities
• Measures ability to purchase assets, satisfy debts, and pay dividends

End

2:00 pm

1.25 hours 

FR&A - Balance Sheet

10:45 am

Understanding the Balance Sheet

Balance sheet is a snapshot of financial and physical assets at a point in time

Assets - provide probable future economic benefits controlled by an entity as the result of previous transactions

Current assets

• Cash and other assets likely to be converted to cash or used up within one year or one operating cycle, whichever is greater
• Presented in order of liquidity, greatest to least

Current liabilities

• Obligations to be satisfied within one year or op cycle, again whichever is greater
• If it meets any of the following it is current:
• Settlement expected during the normal operating cycle
• Settlement expected within one year
• There is not an unconditional right to defer settlement for more than one year

 Current assets - current liabilities = working capital

• Too low = potential liquidity problems
• Too high = inefficient use of assets

Noncurrent assets - provide info about investing activities.  Do not fall under current.

Noncurrent liabilities - provide info about financing activities.  Do not fall under current.

IFRS requires current/noncurrent format, unless liquidity based is more relevant (banking)

Minority Interest - if firm holds controlling interest in a company, this is the portion not controlled

• IFRS - must report in equity
• GAAP - can report in liabilities, equity, or mezzanine

Measurement bases

• Historical cost - what was paid.  Accurate but maybe irrelevant.
• Fair Value - amount at which can be bought/sold at arms length - subjective.
• Note - assets and associated liabilities are usually not netted - reported separated

AR is usually reported net of allowances - this is not a setoff because of nature of the allowance

Inventory

• Must report at lower of cost or net realizable value
• Net realizable  = selling price of inv - estimated cost of completion and disposal costs
• Inventory cost excludes:
• Abnormal amts of wasted materials/labor/overhead
• Storage costs beyond production process
• Admin overhead
• Disposal (selling) costs
• Cost flow assumption (FIFO/LIFO) affects value of inventory
• Standard Costing
• Assign predetermined costs to goods produced
• Retail method
• Measure inventory at retail prices, subtract gross profit to reflect cost

Tangible assets (long term) not used in operations of firm should be classified as investment assets

Intangible assets

• Value of an identifiable intangible asset is based on rights/privileges conveyed to its owner over its useful life
• Cost is therefore amortized over its useful life
• Value of internally produced assets may NOT be recorded on the balance sheet
• Unidentifiable - cannot be separated/sold.  May have an infinite life.
• Do not amortize, but test annually for impairment.
• Goodwill is the best example.
• Intangibles that are purchased are recorded at historical cost less accumulated amortization
• GAAP - Intangibles created internally (R&D) are expensed as incurred
• IFRS requires separation of research and development stages
• Research is expensed, development is capitalized

Goodwill

• When acquiring a company that has goodwill, ignore it in your fair value calc since it is unidentifiable
• This is accounting goodwill - economic goodwill is different and derives from expected future performance of the firm
• Internally generated goodwill is expensed as incurred
• Goodwill is not amortized but test annually for impairment
• Firms can manipulate net income by allocating purchase price to goodwill - lowers D&A expense
• When computing ratios, should eliminate goodwill from balance sheet and impairment charges from income statement for comparability
• Should also evaluate future acquisitions in terms of price paid relative to future earning power of the acquired asset

Financial assets/liabilities

• Assets - investment securities, derivatives, loans, receivables
• Liab - derivatives, notes payable, bonds payable
• Some are reported at cost, some are marked to market
• Marketable securities
• Held to maturity - debt securities with intent to hold to maturity.  Report at amortized cost.
• Trading - trading for near term profit.  Report at fair value.  Report unrealized gain/loss in income statement.
• Available for sale - not held to maturity, and not trading.  Report at fair value.  BUT unrealized gain/loss is in OCI, not the income statement
• For all three, dividends and interest income and realized gains/losses are all recognized in the IS
• Derivatives usually reported at fair value.  Short positions as well.

Owners' Equity

• Contributed capital
• Total amount paid in by common and preferred holders
• Par (when exists) is reported separately
• Authorized - total number authorized.  Issued is what has actually been issued.  Outstanding is issued minus treasury repurchases.
• Retained earnings
• Minority interest - minority shareholder's pro-rata share of net equity of a sub that is not wholly owned
• Treasury Stock - stock repurchased by company.  Has no voting rights and receives no dividends. 
• Accumulated OCI - includes all changes to equity except those recognized in the IS and transactions with shareholders (issuances, treasury, dividends etc)
• US GAAP - can report comprehensive income on IS, separate statement, or in SCOE
• IFRS - not required to report comprehensive income

Statement of Changes in Equity

• Summarizes all transactions that increase/decrease equity accounts over period
• Reconciles beginning/ending balance for each equity account
• Includes transactions w shareholders, and components of accumulated OCI

End

12:00 pm

1.25 hours

FR&A - Income Statement (part 2 of 2)

9:30 AM

Inventory

• Specific identification method - e.g. each vehicle in an inventory
• FIFO - appropriate for limited shelf life items
• LIFO - e.g. coal will sell off the top of the pile
• Tax benefits - higher COGS in inflationary environment
• Weighted Avg Cost Method
• Somewhere between LIFO/FIFO
• Divide total cost of goods available by total units
• FIFO and Wtd Avg Cost are ok under both GAAP and IFRS, but LIFO only under GAAP

Intangible Assets

• Amortization - allocation of the cost of an intangible
• Expense should match proportion of asset's economic benefits used during period
• Most use straightline
• Things with indefinite life (e.g. goodwill) are not amortized but must be tested for impairment at least annually.  Expense any amount of impairment.

Operating/Nonoperating Expenses

• For nonfinancial firm, nonoperating might include investment income/financing expense
• Interest expense is based on capital structure - which is also independent of firm operations

Discontinued Operations

• One you are disposing of but either haven't done so yet or have disposed in current year after the operation had generated income or losses
• Must be physically distinct in terms of assets and operations
• Measurement date - when formal plan to discontinue is made
• Time between this and actual disposal is phaseout period
• Income reported net of tax after income from continuing ops
• Past income statements must be restated
• On measurement date, accrue any expected loss.  Expected gain cannot be recorded until sale completed.

Unusual/Infrequent Items

• Unusual in nature or infrequent in occurrence but not both
• E.g. gains/losses from asset sales/parts of business
• Included in income from continuing operations, reported before tax - must consider this when forecasting

Extraordinary Items

• Under US GAAP, item that is both unusual and infrequent
• E.g. expropriation losses, natural disasters, etc.
• Reported separately, net of tax, after income from continuing operations
• IFRS does not allow these expenses to be separate from operating results in income statement
• Judgment is required to determine if an event is really extraordinary

Changes in Accounting Standards

• Three types
• Change in accounting principle: e.g. FIFO to LIFO
• Requires retrospective application
• Change in accounting estimate - change in judgment, usually due to new information
• Does not require retro application - apply prospectively
• E.g. changing useful life of an asset
• These typically do not affect cash flow
• Prior period adjustment - correction of an error in method or accounting
• Must apply retrospectively and explain
• Again usually do not affect cash flow
• Errors may indicate weaknesses in internal control

Earnings per Share

• Simple capital structure - no dilutive securities
• Complex capital structure - potentially dilutive securities - warrants, options, converts
• Must report basic and diluted EPS

Basic EPS

• EPSb = (net income - preferred dividends) / wtd avg number common shares outstanding
• EPS is earnings available to common - this is why we subtract preferred
• Number of shares is weighted over the year by portion of the year they were outstanding

Effect of stock split/stock dividend

• Each holder will still have same percentage of total shares outstanding
• To calc EPS, first find wtd average
• Convert pre-split amounts to post-split equivalents
• Multiply by months out, and then divide sum by 12
• Done

Diluted EPS

• Dilutive - options etc. that decrease EPS; Antidilutive are the opposite
• Adjust numerator for:
• Convert preferred stock - if dilutive - convert preferred dividends must be added to earnings available to common
• Convert bonds - if dilutive - after tax interest expense of bonds is not considered interest expense for diluted EPS, so interest expense * (1-taxrate) is added to numerator
• Adjust denominator:
• Assume conversion of all dilutive securities
• Consider each security separately to determine if dilutive
• If dilutive was issued during year, only weighs for the portion of the year it was outstanding
• Dilutive options/warrants increase shares out.  No adjustment to numerator.
• Only dilutive when exercise price < avg mkt price over the year
• If dilutive, use treasury stock method

Treasury stock method

• Assumes funds received by company from exercise of options would be used to purchase shares in the market at the average price
• Net increase in shares outstanding is number of shares created by exercising, less the number of shares hypothetically repurchased with the proceeds

Antidilutive securities are NOT included in diluted EPS

• Antidilutive might include conversion of preferred - not having to pay preferred dividend is good, and if this outweighs effect of additional shares you are fine

Changes in EPS

• Notes will typically explain - e.g. shares were repurchased

Comprehensive Income

• Includes all changes to equity other than owner contributions and distributions
• Aggregates net income AND other comprehensive income
• OCI = foreign currency translation gains/losses, pension liability adj, unrealized gains/losses on cash flow hedging derivs and available for sale securities)

Transactions that affect equity but do not show up on income statement

• Issuing stock / reacquiring stock
• Dividends
• OCI

End

10:45 AM

1.25 hours

FR&A - Income Statement

5:15 PM

Understanding the Income Statement

Revenues - sales of goods and services.  'Sales' is not synonymous - might just be one component of revenues

Net revenue - revenue less allowance for returns/allowances

Expenses are amounts incurred to generate revenue, grouped together by the nature of their function

Gains/losses - incidentals, outside primary business activity

Single-step - all revenues grouped, all expenses grouped too.  Multi-step - includes gross profit calc

If a firm has a controlling interest in a sub, prorata share of sub's income that the firm does not own is reported in parent co's income statement as minority owners' interest - you must subtract this because if a firm controls, it has to include the whole income in its income statement

Revenue recognition

• IASB - 'income' includes revenues and gains - increases in economic benefits during period in form of inflows or enhancements of assets or decreases of liability that result in increases in equity, other than those relating to contributions from equity participants
• FASB - recognize when realized and earned
• Evidence of arrangement between buyer/seller
• Product has been delivered/service rendered
• Price is determined or determinable
• Seller is reasonably sure of collecting money

Long term contracts

• Percent completion method - divide cost to date by total cost
• Completed contract method - project cost can't be measured or project is short - only recognize when project is complete
• Under either, if a loss is expected, must recognize immediately
• IFRS - if can't reliably measure, bill revenue when costed, expense costs when incurred, and recognize profit only at completion
• Cash flow is same under both methods
• Percent method is slightly more aggressive and uses estimates, but also smooths earnings

Installment sales

• Firm finances transaction and receives payment over extended period
• If collection certain, then recognize rev right away
• If uncertain, use installment method
• Recognize profit as installments are received
• Cost recovery method
• Only recognize when cash collected > costs incurred
• IFRS defines when to use installment method - date when property is transferred and date buyer acquires vested interest may differ - risk and rewards of transfer may not be there right away - uncertainty of transaction completion

Barter transactions

• Round trip transaction - exchange of almost identical goods - ex. internet companies buying ad space on each others' sites - should this be a sale?
• GAAP - only if firm has historically received cash payments for such goods/services, and record at fair value based on historical experience
• IFRS - revenue must be based on fair value of revenue from similar nonbarter transactions with nonrelated parties

Gross/Net Revenue Reporting

• Gross - report revenue and COGS separate
• Net - only report the difference
• GAAP - to report gross, you must be primary obligor, bear inventory and credit risk, be able to choose supplier, and have latitude to establish price

Analyst should consider:

• How conservative are revenue recognition policies (too soon is aggressive)
• Extent to which policies rely on judgment/estimates

Expense Recognition

Matching Principle - expenses to generate revenue are recognized in same period as said revenue

• Not all expenses are tied to revenue - period costs, like administrative, are expensed in the period incurred
• Depreciation of machines
• Warranty expenses and bad debt expenses - recognize in period of sale, not in future

Concerns

• Expenses contain estimates - delaying expenses inflates earnings
• Consider reasons for expense estimate changes
• Compare a firm's estimates to its peers
• Check footnotes!

Depreciation

• Straight-line: Depreciation = (cost - residual value) / useful life
• Accelerated: DDB - applies constant rate
• Note - does not explicitly use residual value, but ends once resid value is reached
• DDB depreciation = (2/useful life) * (cost - accumulated depreciation)
• If no residual, it will never reach it - so usually switch to straight line at some point

Break

6:15 pm

1 hour

FR&A - Financial Reporting Standards

4:35 pm

Objective of reporting: provide economic decision makers with useful information about a firm's financial performance and changes in financial position.

Standard setting bodies - professional organizations.

• FASB - US GAAP
• IASB - IFRS
• Goals
• Develop standards requiring transparency, comparability, high quality in statements
• Promote use of global standards
• Account for needs of emerging mkts and small firms in standards
• Achieve convergence between countries standards

Regulatory authorities - government agencies with legal authority to enforce compliance.

• SEC in US, FSA in UK
• Filings required
• 10K (40-F in canada, 20-F for others)
• 10Q (does not have to be audited)
• DEF 14A - for proxy votes
• 8K - material events
• 144 - nonregistered issues of securities
• 3, 4, 5 - beneficial ownership of securities by officers/directors
• IOSCO - Int. Org of Securities Commissions

People disagree on best treatments for certain items.  Business/interest groups are another barrier to convergence in standards.

IFRS Framework

• Understandability - reasonable effort, and basic knowledge of business/accounting
• Comparability - consistent among firms and across time
• Relevance - can influence economic decision, evaluation of past/future.  Timely and detailed.
• Reliability - unbiased and error free
• Substance over form - present economic reality not just legal form
• Prudent/conservative
• Complete (within limits of cost/materiality)

Item should be recognized in financial statement if future economic benefit is probable and item's value/cost can be measure reliably

Measurement - historical, current (what you'd have to pay today), realizable (what you could sell for), present value, and fair value (what two parties in an arm's length transaction would exchange for)

Tradeoffs in reporting - reliability/timeliness, cost of info, intangible information

Going concern - company will continue to exist for foreseeable future

Required statements - BS, IS, CF, SCOE, explanatory notes

Principles for preparing - fair presentation, going concern basis, accrual basis, consistency, materiality

Principles for presenting - aggregation of similar items, no offsetting unless permitted, classified balance sheet (current/noncurrent), minimum info on each statement, comparative info for prior periods

Differences between FASB and IASB

• Purpose - FASB's framework is not at top of GAAP hierarchy like IASB's is - IASB requires mgmt to consider framework if no explicit standard exists, FASB does not
• FASB has different objectives for business and nonbusiness reporting - IASB has one
• IASB places more emphasis on going concern assumption
• FASB = relevance and reliability, IASB = FASB + comparability + understandability
• IASB lists income/expenses as related to performance, FASB uses rev/exp/gains/losses/OCI
• FASB says "asset" is a future economic benefit, IASB defines it as resource from which benefit is 'expected'
• FASB uses 'probable' to define assets/liabilities, IASB uses 'probable' to define criteria for recognition (wtf does this mean?)
• FASB does not allow value of most assets to be adjusted upward

SEC requires foreign firms that issue securities in the US to reconcile financials to US GAAP

Special standards will still apply to certain industries even after convergence

Coherent framework is transparent, comprehensive, consistent

• Barriers to this include valuation practices (measurement bases), standard setting (principles, rules, or objectives based), and measurement (proper value of elements) - e.g. is IS or BS more significant

Must be aware of systems, and new transactions and how those fit with systems.  Can monitor IASB and FASB websites and CFAI.  Analyst should use footnotes and disclosures.

Companies must disclose likely impact of recently issued accounting standards.  Management might be evaluating whether to adopt - be aware of the risk.

End

5:15 pm

.667 hours

FR&A - Reporting Mechanics

Start 4:20 pm

Financial Reporting Mechanics

Unearned revenue = liability
Gains = count as revenue

Accounting equation:

• Assets = Liabilities + Equity
• Expanded: Assets = Liabilities + contributed capital + ending retained earnings
• OR Assets = L + contributed capital + beginning RE + revenue - expense - dividends

Double entry accounting

Need for accruals

• Unearned revenue - cash goes up, liability goes up
• When recognized, liability goes down, sales goes up
• Accrued revenue - firm provides good before it receives cash
• Prepaid/accrued expenses
• Effect is to recognize expense in the proper period

Changes in asset values are gains/losses, or shown in 'other comprehensive income'

Accounting system

• Journal entries for every transaction > general journal
• General ledger organizes entries by account
• End of each period, initial trial balance is prepared, then adjusted if needed
• Account balances from adjusted trial balances is presented in financial statements

Crucial for an analyst to look at MD&A.  Can help spot things that look out of line.

End

4:35 pm

0.25 hours

FR&A - Introduction

Start 4:00 pm

Financial Statement Analysis: An Introduction

Objective of reporting per IASB:

• Provide information about the financial position, performance, and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.
• Income statement - revenues and expenses are ongoing, gains and losses are peripheral
• Balance sheet - firm's financial position at a point in time.  Assets = liabilities + owners equity
• Cash flow - operating, investing, financing
• Statement of changes in owner's equity - amounts and changes in equity over time

Footnotes - accounting methods, assumptions, and estimates.  These are audited.  Also has info on contingencies etc.  Note that supplementary schedules are NOT audited.

Supplementary schedules - operations by region/segment, reserves (oil/gas), hedging activities and financial instruments.

MD&A - from perspective of mgmt.  In US they MUST discuss

• results from ops, with discussion of trends in sales/expenses
• Capital resources/liquidity, discuss trends in cash flows
• General business overview on known trends

Can also include accounting policies, uncertainties, forward looking data, liquidity events, discontinued ops, disclosures for interim financials, discussion of segments.

Audit - independent review with objective to provide opinion on fairness and reliability of statements

Audit opinion

• 3 parts which state:
• Audit is independent
• Audit standards were followed so this is reasonable assurance that statements contain no material errors
• Auditor is satisfied that appropriate standards were followed.  Must also contain a report of where accounting methods were not consistent between periods.
• Results:
• Unqualified - free from material omissions/errors
• Qualified - there are exceptions and these are explained
• Adverse - statements are not fair
• Also will contain explanatory paragraph if material losses are possible but not measurable
• Must state an opinion on company's internal controls
• Firm's must avow to this and it is their responsibility

Other sources of information

• Quarterly/semiannual - not necessarily audited
• Proxy statements - when a shareholder vote is required
• Corporate reports/press releases - sales material of company
• Other economic/industry data.  Comps, trade journals, stats services, government agencies

Framework - 6 steps

1. State objective
2. Gather data - including talking to mgmt
3. Process data
4. Analyze and interpret
5. Report conclusions - remember code and standards
6. Update analysis and change conclusions when necessary

End of reading.

4:20 pm
.33 hours

Check in

Finally done with economics.  So many of those concepts seem very similar and tend to rely on the same principles - the key relationship is the impact of interest rates on aggregate demand.

Economics taken as a whole seems like one big blur of a does b does c does d, repeat but slightly different, so I anticipate that prepping it effectively is going to depend a lot on just getting more familiar and repeating the concepts and taking note of counterintuitive results.

I think with the remainder of today I'll get a start on Financial Reporting and Analysis.  Should again be quite a bit of review, and this section more than any I will probably be skimming and looking for strange CFAisms than actually focusing on the core concepts.

Economics - Fiscal and Monetary Policy and Central Banks

Start 1:15 pm

Fiscal Policy

Fiscal policy is the taxing and spending decisions of the government

• Budgets = Tax Revenues - Govt Expenditures
• Surplus, Deficit, and balance = pos, neg, 0
• Goal is to stabilize cycles
• During inflationary times: increase taxes/reduce spend
• During recession times: decrease taxes/increase spend

Supply Side Effects - fiscal policy (esp tax) affects LRAS

• Income taxes reduce incentive to work - tax wedge b/w pre and after tax wages
• Reduces potential GDP because it reduces labor supply
• Increase in consumption taxes has a similar effect - reduces purchasing power of wages

Laffer Curve

• Plots total tax revenue as function of tax rate
• Supply side effects mean it eventual goes down
• Laffer begins and ends at 0 tax revenues, at 0% tax and 100% tax

Investment

• Major component of GDP - spending on fixed productive assets and inventory
• Sources of investment financing: national savings, borrowings from foreigners, government savings
• Gov surpluses increase investment spending (and vv)
• Taxes on capital income directly impact investment
• Larger deficits require governments to borrow, increasing interest rates and decreasing investment
• This is the crowding out effect
• BUT there is also the Ricardo Barro effect
• Since increases in deficit mean higher taxes in future, people will increase savings to offset effect of higher tax in future
• Ricardo Barro Equivalence - goes further and says borrowing or taxes are the same net effect
• In reality it is probably somewhere between the two - there is crowding out, partly offset by reduced consumption

Generational Effects - effects of postponing imbalances

• Equal to present value of future expected deficits
• Major source of imbalance in the US is Medicare
• Generational Imbalance - PV of govt benefits to current generation is not fully paid by the taxes on the current generation
• Current policy is to just postpone

Discretionary Fiscal Policy

• Actions of fiscal policy meant to stabilize the economy
• Changes in spending have magnified effects on aggregate demand
• Government Expenditure Multiplier - final effect per dollar change on agg demand
• Applies equally to increases/decreases
• Changes in taxes also have magnified effect but smaller due to savings
• Autonomous Tax Multiplier
• Since Gov Ex Mult > Autonomous Tax Mult, the Balanced Budget Mult > 0
• Increase in spending with equal increase in taxes will net expand the economy
• Limitations
• Economic forecasts may be wrong
• There can be significant delay in recognition, administrative/lawmaking, and actual impact/implementation

Automatic Stabilizers - built in devices triggered by state of economy

• Induced taxes
• As incomes rise, so do tax rates/revenues
• Needs tested spending
• E.g. unemployment benefits are paid more (i.e. spending stimulus increases) in a recession and less in a boom
• Both actions are countercyclical
• These both also affect the budget deficit; budgets have a structural and cyclical component
• Structural is what there would be if at full employment
• Cyclical exists because economy is above or below proper GDP
• Cyclical is 0 when economy is at right GDP

Monetary Policy

Goals

• 3 main goals: Maximum employment, stable prices, moderate long-term interest rates
• Increase money supply commensurate with growth of economy (monetarist)

Fed focuses on core inflation - increase of CPI excluding most volatile components (food and energy) - and inflationary/recessionary output gaps

• CPI calc is also adjusted for overstatement bias
• Don't worry about output gap calc but just know it is important to the fed
• If output too high, decrease money credit aggregates
• If output too low, increase money supply

Implementation of policy

• Mainly happens through changing federal funds rate - increase rate to decrease supply and vv
• Rules for implementation - Fed decides b/w instrument rules and target rules
• Instrument rules - base target rate on current performance of economy
• Taylor Rule - targeting 2% inflation, FFR = 2% + actual inflation + 0.5*(actual inflation - 2%) + 0.5 (output gap)
• With no output gap and inflation at target, FFR = 4%
• Fed doesn't explicitly follow but this trend is pretty solid for last 20 yrs
• Targeting rules - based on a future forecast of inflation
• Requires FFR be set so forecast inflation = target inflation (2%)
• Accomplishes this through open market ops to influence supply/demand
• This is the fed's most commonly used tool

Example chain of events - policy action to final goal

• Goal is to stimulate economy and growth

1. Fed buys treasuries, this increases banks reserves
2. Reserves decrease the FFR as banks will lend their excess reserves
3. Other interest rates decrease as supply of loanable funds increases
4. Long-term rates also decline
5. Decrease makes investment in other countries attractive; reduced demand for US dollars; dollar depreciates
6. Decrease in rates on loans means businesses invest
7. Consumers increase purchases of durables
8. Demand for exports increases
9. 6, 7, and 8 mean aggregate demand goes up
10. Increase in aggregate demand means price, employment, and inflation all go up

Loose links

• Link between short and long term rates is loose
• Significant time lag - can make cycles more severe if it is really lagged

Other Monetary Policy Rules (non-Taylor) and why the Fed doesn't use them

• McCallum Rule - focuses on quantity theory of money
• Matches growth of money to long term real GDP growth, adds target inflation, and adjusts for changes in velocity of money
• Drawback: demand for money can cause variations in interest rates and therefore demand
• Friedman - similar
• Grow money proportional to potential real GDP
• Drawback: fluctuations in money velocity and demand can lead to interest rate swings
• Exchange Rate Rule
• Keep exchange rate constant to a basket of other currencies
• This is bad - you just get the inflation of all the other countries
• Inflation Targeting
• Practiced by many central banks
• Use open market ops to target stated inflation rate, usually 2% +/- 1%
• Very transparent and predictable
• Still debatable if this or Taylor is better

Overview of Central Banks

• Primary function: control a country's money supply
• Goals are usually price stability and max sustainable GDP growth
• Countries' goals vary mainly in how much emphasis there is on promoting growth
• Usually issue currency and regulate the banking system

Three policy tools in U.S.

• Discount rate - rate at which banks can borrow from Fed - lower rate, more funds
• Bank reserve requirements - higher reserve means less money supply
• Only works if banks willing to lend and consumers to borrow
• Open Market Operations - buying/selling treasury securities
• This is the most common tool

Tools in the other countries are essentially the same

• UK - repo rate is the interbank rate
• Australia - cash rate
• Canada - overnight rate

Federal Funds Rate is market determined - but central bank usually changes discount rate at same time

Using either discount or overnight rate, goal is to keep inflation in bounds

Inflation-targeting is the goal in most countries, exceptions are the US and Japan.  Most countries target 2% with acceptable range of 1-3%.  Measure of inflation can vary - core/non-core etc.

Implementation is complex - policy changes that promote growth might also cause inflation.  Changes in interest rates affect asset prices, income from saving/lending, investment flows b/w countries, forex, and import/export levels.

End

2:45 pm

1.5 hours

Economics - Macro - Inflation, Unemployment and Business Cycles

Start - 12:30 pm

Inflation vs. price level

• Inflation is persistent increase in price level over time; erodes purchasing power
• Prices of almost all goods are increasing

Demand pull inflation vs. cost push inflation

• Demand pull
• Caused by anything that increases demand
• Rising real wages mean that SAS will decrease and P will increase
• If government tries to stop it, it will just repeat the process
• Cost push
• Caused by an initial decrease in SAS - e.g if energy becomes expensive
• This decreases real output below the LRAS level
• If this brings about a policy response to increase demand, demand rises as well as price
• This happened in the 1970s oil crisis

Costs of inflation

• Costs of high inflation can be high even when anticipated properly
• Diverts resources to deal with inflation's effects/uncertainty
• Decreases value of currency used in transactions and as store of value
• Reduces real returns of investments (taxed on nominal basis)

Nominal rate of interest is the eq rate in the market for savings/investment

• Higher inflation = business will expect greater returns
• Higher rates of growth of money supply = higher inflation, expected inflation, interest rates

Inflation and unemployment - more inflation, overemployment in short term

• If expected and actual are equal, economy is at full employment
• If inflation (increase in agg demand) greater than expected:
• Price increases more than expected
• Unemployment decreases to level below natural rate
• You move at a point along the downward sloping Philips Curve
• Philips curve shifts when expectations shift

Changes in natural rate of unemployment are caused by:

• Size and makeup of labor force changes
• Changes in labor mobility
• Advances in tech
• Increase in natural rate = shift Philips to the right

Business cycle - fluctuations in economic activity

• Two phases - expansion and contraction/recession
• Turning points are peak and trough
• Recession - significant decline in economic activity lasting more than a few months
• Expansion - growth positive, unemployment down, inflation up
• Reverse true in recession

Theories on why business cycles happen

• Mainstream view - caused by variability in aggregate demand around true LRAS
• Keynes - swings are due to swings in level of optimism of business owners
• Monetarists - swings are due to money supply errors
• New Classical - only unexpected changes in demand lead to cycles
• Real business cycle theory
• Emphasizes effect of real economic variables
• Technology a key driver - changes productivity
• Real GDP can thus fluctuate, different that assumption that GDP is steady

End

1:15 pm

0.75 hours

Economics - Macro - Money, Price Level and Inflation

Start 11:00 am

Money, Price Level and Inflation

Functions of money

• Medium of exchange or means of payment
• Unit of account
• Store of value

Measures of money in US

• M1 - all currency NOT held at banks, traveler's checks, and checking account deposits of individuals and firms (but not govt checking accts)
• M2 - all of M1 plus time deposits, savings deposits, and mmmf balances
• Note: checks and credit cards are not money, they are just transfers

Institutions

• Commercial banks - intermediary between savers and borrowers
• Thrifts - savings banks, credit unions, and S&Ls
• Money mkt mutual fund - an investment company - offer slightly less liquidity than other two

Economic functions of institutions

• Create liquidity - make loans or purchase debt securities
• Financial intermediary - lower cost of funds for borrowers
• Monitor risk of loans
• Pool default risk

Regulation of banks and their balance sheets

• Minimum amount of equity must be maintained to align incentives
• Reserve requirements (portion in cash/US Fed deposits)
• Restrictions on types of deposits various institutions may accept
• Rules about proportions of various loan types institutions can make

There has been lots of financial innovation - overall has led to a shift from checking accounts at commercial banks to checking accounts at thrifts, and from savings accounts to mmmfs

Role of the US Federal Reserve - keep inflation low, promote growth and employment, reduce business cycles

• Federal funds rate - rate at which banks loan to each other on an overnight basis
• Fed influences this rate through the supply of money
• Policy tools (3)
• Discount rate - rate at which banks can borrow from Fed - lower rate encourages lending and decreases interest rates
• Reserve requirements - increasing this decreases supply of money
• Only works well if banks willing to lend and customers willing to borrow the additional funds made available
• Open Market Operations - buying/selling Treasuries by Fed on open market - buying means more money in the market.  Most commonly used tool.

Fed Balance Sheet

• Assets - gold, deposits of other central banks, SDR at IMF, US treasuries (90%), loans to banks
• Liabilities - mostly cash (90%).  Bank reserve deposits are a small portion.

Creation of money

• In fractional reserve system, excess reserves can be loaned
• Multiplier effect as money is spent and deposited and respent
• If reserve ratio is 25%, each $1 in excess reserve will become $4
• When fed uses open market ops, it increases/decrease bank reserves
• Expansion of money is dampened by amount of proceeds held in cash
• Money multiplier therefore accounts for this:
• Multiplier = (1+c) / (r+c)
• c = currency as % of deposits, r = required reserve ratio
• Change in quantity of money = change in monetary base * money multiplier

Demand for Money

• That is, demand for balances held in form of ready cash
• Demand for money is driven by interest rates - higher interest rates, less money demand
• Rise in real GDP increases demand for real money - shifts up
• Technology has overall reduced the demand for money

Supply of Money

• Determined by Fed and therefore independent of interest rate - vertical
• Equilibrium interest rate equates the supply and demand for money
• Usually talk about this in real terms - i.e. inflation does not increase demand for real money

Determination of interest rates

• Interest rate is equilibrium between supply and demand for money
• Central bank can shift money supply left and right

Impact on GDP

• More money/lower interest means
• Businesses invest more and households increase durable consumption - so C and I both increase
• Investment less attractive to foreigners - exchange rate decreases - exports increase
• This is compounded by the multiplier effect
• Increase in demand will increase real GDP and price level
• If economy is at full-employment, the increase in real GDP must be temporary
• Increase in demand makes demand for wages rise, than SAS falls
• Thus long run effect of increase in money supply is just a rise in prices
• Increase in price level offsets the increase in money supply

Quantity of Money: MV = PY

• Quantity theory of money:
• M = money supply, V = velocity, P = price, Y = real output
• MV = PY
• P = M(V/Y)
• V and Y both change very slowly, so change in M results in proportional change in Y
• Monetarists think you should only increase M with Y so as to maintain a stable P
• Can estimate inflation with GDP and money supply growth
• Inflation = money supply growth - GDP growth

End

12:00 pm

1 hour

Economics - Macro - Aggregate Supply and Aggregate Demand

Start 10:00 am

Aggregate Supply and Aggregate Demand

Aggregate supply = amount of goods and service produced by an economy.  A function of the price level.

In short run, higher prices = higher output.

Long run aggregate supply is vertical, short run slopes up

Adjustment to definitions of short run and long run:

• Short run - period over which wages are fixed

Key factor that drives workers' wage demands is expectations about future inflation

• Higher inflation means workers want higher wages and decreases their short term supply
• Higher wages increases marginal costs of productions, employers produce less at each price level

LRAS represents supply of goods/services when workers' expectations = actual inflation

• Change in actual inflation doesn't shift short run agg supply - you move along the line to a temporary disequilibrium
• In the long run, expected inflation must = actual inflation = production at full employment GDP
• As workers' expectations match actual, SRAS shifts to return to equilibrium

Determinants of LRAS

• Not affected by price level
• It is the potential real output of the economy
• Fully determined by the quantity of labor, capital, and technology of the economy
• To shift LRAS:
• Full-employment Q of labor changes
• Amount of capital in economy changes
• Technology improves productivity of K, L or both

To shift SRAS

• Same things that shift LRAS, to start (when LRAS shifts, SRAS comes too)
• e.g. in expansion of technology, everything moves to the right
• If wage rates or prices increase, SRAS will shift left, decreasing SR aggregate supply
• Wage rates are impacted by employment levels and inflation expectations

Aggregate demand: relation between price level and real Q of final goods and services demanded.

Components of aggregate demand

• Consumption
• Investment
• Government spend
• Net exports

Aggregate demand is down sloping - at higher prices, all should decrease

• Wealth effect - when prices go up real wealth decreases, so there is less spend
• Substitution effect - increase in interest rates increases the cost of current consumption

To shift aggregate demand - lots of things can shift agg demand

• Expectations about incomes, inflation, profits
• Inflation - you expect higher future prices - buy now (increase demand)
• Higher incomes - you expect more money to come, so buy now
• Increased profits = businesses invest more
• Fiscal/monetary
• Increase in G spending
• Lowering taxes or increasing transfer pmts might increase discretionary income
• Increase in money supply = decrease in interest rates
• State of world economy
• Influence through net exports
• Foreign incomes up = higher demand for US products, X increases
• Exchange rate increase = your goods are more expensive, and you import more, so X decreases

Macroeconomic equilibrium

• If prices temporarily too high, this is a recessionary gap
• If prices temporarily too low, this is an inflationary gap
• Difference between real GDP and full-employment GDP is called recessionary gap or output gap
• Changes in SRAS are driven by changes in aggregate demand
• Say demand increases
• Intersection of SAS and AD now out to the right and higher
• Real wages are lower bc wages in SAS are fixed and prices now higher
• Firms try to produce more, leading to even more demand for wages
• SRAS contracts in response (it is more expensive to provide each good)
• Decrease in demand does the opposite - wages go up, demand for wage increases goes down, this in turn increases SRAS

Classical, Keynesian, and Monetarist Schools

• Classical - shifts in AD and LRAS primarily driven by technology over time
• Adjustments in wages/LRAS should be fairly quick
• Strong tendency toward economic equilibrium
• Taxes were the impediment to equilibrium
• Depression did not support this view - long term unemployment, business cycles very severe
• Keynes - wages are 'downward sticky'
• This reduces ability of economy to increase SAS
• New Keynesians - prices and other productive inputs also downward sticky
• Policy prescription: 
• Increase agg demand through monetary policy (increase money supply) 
• Fiscal policy (increase gov spend, decrease tax, or both)
• Monetarists
• To keep demand growing/stable, central bank should steadily and predictably increase supply of money
• Recessions are caused by inappropriate decreases in money supply
• Money wage rates are downward sticky (similar to keynes)
• Similar to classical though in they want low taxes, minimize disruption of taxes

End

11:00 AM

1 hour

Economics - Macro - Jobs and Price Level

Start 9:30 am

Definition of unemployed:

• has actively searched for a job in past 4 wks OR
• has been laid off and is waiting to be recalled OR
• will start a new job in next 30 days

Unemployment rate = number unemployed / labor force * 100

• Labor force = all people actively employed or actively seeking employment

Labor force participation rate

• Rate = labor force / working age population
• Working age pop = all people 16 or over not living in institutions
• Fluctuates due to discouraged workers - available to work but neither employed nor seeking

Employment to population ratio

• epratio = number of employed / working age population * 100

Aggregate hours = total number of hours worked in a year by all employed people

• Allows us to estimate productivity of labor - output produced per hour of labor
• Higher productivity = higher wages
• Real Wages = money wage rate adjusted for changes in overall price level
• Calculated using total labor compensation = wages, salaries, and benefits

Three types of unemployment

• Frictional - results from changes in economy that prevent qualified workers from being matched to existing jobs in a timely manner
• Structural - caused by structural changes in economy that eliminate jobs and makes other jobs - employees need to retrain (do not have necessary skills for existing jobs)
• Cyclical - caused by changes in general level of economic output.  

Measures of unemployment

• Full employment - when there is no cyclical.  There is still friction and structure unemployment tho.
• Natural rate of unemployment = frictional + structural
• Potential GDP - level of GDP country can produce at the natural rate (relates to cyclical)

Consumer Price Index

• Best known indicator of US inflation - basket of goods - reported monthly
• Selects basket, records prices in 30 urban areas, calculate CPI
• CPI = cost of basket at current / cost of basket at reference * 100

Inflation Rate = %yoy change CPI

CPI Bias

• New goods - products replace by newer but initially more expensive items
• Quality improvements - price increase not inflation, but quality driven
• Commodity substitution - people switch based on cost to similar products - CPI overstates
• Outlet substitution - people shop at discount centers reducing cost not capture in CPI
• This all results in CPI being upward biased, estimate is by about 1%

End

10:00 am

0.5 hours

Economics - Macro - Markets for Factors of Production

Start 4:45 pm

Markets for Factors of Production
Understand how demand for inputs of production is determined and what factors influence elasticity, esp for labor.  Also how does market for financial capital establish price (interest rate) and factors that affect supply and demand for capital.  Last, understand components of payments to productive resources (opp cost and economic rent).

Demand for productive resource is depends on demand for final goods it will produce - thus this is a derived demand.

• Marginal Product of a resource - additional output of final product produced by a unit of input, holding others constant - aka "marginal physical product"
• Marginal Revenue - addition to total revenue from selling one more output unit
• Equal to price for a price taker
• Marginal Revenue Product - revenue generated by selling the product from one unit of input and holding other inputs constant
• Downward sloping for any range of output where there are diminishing marginal returns to inputs
• This curve is in fact the firm's short run demand curve for the input

Firm will pay for one more unit of labor equal to the addition to total revenue from that labor

• MRP of labor = Price of labor
• This determines the equilibrium wage rate - highest price a firm will pay to hire an additional unit of labor

Demand for labor

• Increase in price of output increases demand for labor, and vv
• Price increases the marginal revenue which increases MRP of labor, and vv
• If another factor of production changes price, depends whether it is compliment or sub to labor
• If substitute, decrease demand (e.g. phone systems replacing cust service)
• If complement, increase demand (e.g. IT professionals)
• Technology in general has increased the demand for labor - evidenced by increases in real wages

Elasticity of Demand for Labor

• More elastic in long than short run
• Short run is defined as period in which it is fixed
• Will see a greater decrease in demand for labor when there are substitutes (e.g. machines)
• More labor intensive = higher elasticity
• E.g. warehouse (lots of workers) vs. airline (not many pilots)
• If labor and K can be substituted easily, e.g. machines and robots replace humans

Work/Leisure

• Leisure is a normal good, so people want more of it
• Employers need to make wage high enough to give up leisure for employment
• Wages are the opportunity cost of leisure
• Higher wages, more leisure you will give up
• This is substitution effect - subbing out leisure so you can work instead
• As a worker's wage increases, his demand for goods increases, including his demand for leisure
• This is income effect 
• On supply curve, upslope is substitution, and it bends backward due to income at some max quantity of labor

Other factors that affect labor supply:

• Size of adult population
• Capital accumulation in items that improve home productivity - greater proportion can work outside the home (automatic food preparation)

Labor unions

• Organized so workers can bargain for wages via collective bargaining
• Can restrict supply by refusing to work
• Can work to increase the demand for union labor
• Increase marginal product of workers through training
• Encourage people to buy union made products (advertisements)
• Influence trade restrictions on imported goods (e.g. steel)
• Can also reduce supply of substitutes for union labor (increasing price of substitutes)
• Increase in min wage for unskilled labor, since unskilled might be a substitute
• Restricting immigrants is another tactic

Monopsony

• Buyer of a good or productive asset has market power
• Opposite of a monopoly
• If employer pays a single wage, increasing wage to hire more workers means paying all workers more
• Marginal cost of additional labor is higher than in perfect competition
• Results in underemployment and DWL
• Monopsonist hires fewer workers even though marginal revenue product of an added worker is greater than the wage rate
• When facing a monopoly labor supplier (union) final wage rate will be somewhere between monopsony (too low) and price from union's reduction of labor (too high)

Physical and Financial Capital

• Physical is the physical assets of the firm - PP&E, inventory
• More demand for physical = more demand for financial capital (money raised through issuing securities) to buy more physical capital
• We equate MRP of capital to the Cost of Capital
• MRP of capital is future MRP so current value is the present value of MRP
• Cost of Capital is cost of funds firm must raise - think of MRP as returns over time (in percent terms) and then MRP must equal interest rate on capital

Demand for Financial Capital

• Downward sloping derived from its MRP curve
• Downward function of the interest rate - low interest, high demand and vv, for both physical and financial capital
• Note: Labor produces right away, capital takes time - so you need present value of MRP

Supply for Financial Capital

• Upward function of the interest rate
• Suppliers are savers - face choice of consume now, or later
• Savings affected by:
• Interest rates - higher means more savings (put it in the bank)
• Increases in current income (decreases do opposite)
• Expected future incomes increase means less savings (if they decrease, you will save more now)

Equilibrium of supply and demand in capital markets determines interest rates

Renewable/Nonrenewable resources

• Renewable - a water well - Q always same, price changes
• Price determined by demand - quantity is fixed
• Land also falls in this category
• Supply is therefore perfectly inelastic 
• Nonrenewable - an oil well that depletes over time - price always same, Q changes
• Depends on known stock - this is fixed at any one time
• Known stock will generally increase with tech that makes more resources available
• Rate at which source is supplied - flow supply - perfectly elastic at a price that equals present value of expected next period price
• Hotelling Principle
• If price of oil expected to rise faster than Rf rate, oil producers will wait on production now and produce more in the future
• If price of oil expected to rise slower than Rf, oil producers will produce now and then sell and invest proceeds in Rf rate
• Thus, price of oil is expected to rise at a rate equal to Rf

Economic Rent vs Opportunity Costs

• Difference in income is due to difference in MRP (movie star vs. car wash worker)
• Opportunity cost = what you would make in your next best opportunity
• For an actor this could be quite large
• Difference between earnings and opportunity cost = economic rent
• Ex, a TV actor might get accept getting paid considerably less
• Economic rent is similar to concept of Producer Surplus and depends on supply curve shape for the resource
• Inelastic - all economic rent
• Perfect elastic - no economic rent
• If factor of production easy to create/supply, economic rent reduced by competition
• If difficult, that resource has high MRP, and gets significant economic rent
• Scarcity is not enough - a good curler is rare, but not as valuable as a good soccer player

End

6:00 PM

1.25 hours

Economics - Macro - Perfect Competition, Monopoly, Monopolistic Competition, Oligopoly

Start 1:15 PM

Perfect Competition

Price takers are firms with perfectly elastic demand curves - can sell everything at market price, but if they go higher, they sell nothing.  Market price is a given.  This is equivalent to perfect competition.

Assumptions:

• All firms in market produce identical products
• Large number of independent firms
• Each seller small relative to size of total market
• No barriers to entry/exit

Producer firms have no influence over mkt price!

Firms increase production until MR=MC, thus maximizing economic profit.  For a price taker, MR = Price = demand curve = horizontal line.

• Economic loss occurs for any units sold where MR < MC
• To find economic profit, total revenue less total costs
• Equal to a rectangle at Q with horizontal line at ATC
• In equilibrium, firms will not earn economic profits for any significant time
• Firms enter and price decreases to ATC
• All firms just produce at the minimum of the ATC curve

Firm should still operate if P < ATC but still greater than AVC - as long as you are covering some of your fixed costs, operate

• If P = AVC, this is the shutdown point - if P < AVC, losses will be greater than fixed costs
• Shutting down will limit losses to fixed costs

Long run equilibrium output level for perfect competition is MR = MC = ATC

Short run supply curve is the MC line above the AVC.  Market is the sum of these curves.

Changes in Demand, Entry/Exit, Plant Size

• Increase in mkt demand - increase P and Q in short run
• Firms expand production and enter
• 
  
• Decrease does opposite
• Firms either decrease production (downsizing) or shut down in long run
• If an industry is characterized by economic profits, firms enter and drive down price by shifting supply curve outward
• Individual firms produce less though, because price is lower - move along its own supply curve
• Therefore, total revenue and economic profit will decrease
• If industry characterized by economic losses, firms exit and drive up price, firms produce more, and total revenue will increase and economic loss will decrease

Permanent changes in demand/tech

• Permanent change in demand - leads to entry or exit of firms from industry
• Demand shifts out
• Price increases, Q increases
• Firms realize economic profit
• New firms enter
• Supply curve shifts out
• Come back to initial price
• Firms produce more in aggregate, but each go back to same production
• Long run eq price might be higher or lower after increase in demand
• Depends on effect of demand for inputs
• External economies of scale - input prices fall because of greater demand
• Negative sloping industry supply curve
• External diseconomies of scale - increase demand leads to greater prices
• Positive sloping industry supply curve
• Technological changes
• Take some time to set in - costly
• Supply curves shift to the right and supply more product at lower price
• First movers will earn economic profits
• New firms will be attracted
• Existing firms will experience economic losses - adopt new tech or exit

Monopoly

Characterized by one seller of a specific, well defined product with no good substitutes.  Barriers to entry are high.

• Legal barriers - e.g. patents, copyrights, and govt franchises (USPS), utilities
• Natural barriers - large economies of scale, e.g. electric utility.
• Downward demand curve - unlike price takers, monopoly must set price so that P and Q maximize profits (assuming no price discrimination)

To maximize profit, expand output so MR = MC

• Does not attract other market entrants due to barriers - thus economic profits exist
• Demand must lie above ATC in order to make profit
• Profit = (P - ATC) * Q
• Monopolists are price searchers and have imperfect information regarding demand
• Must experiment to find profit max'ing quantity

Price discrimination - charging different customers different prices for same product

• To work, must have downward demand curve and at least two groups of customers with different price elasticities of demand
• Must also be able to prevent sellers from reselling the product
• Compared to perfect competition, monopoly reduces consumer surplus by DWL triangle
• Less than efficient quantities are being produced
• Price discrimination reduces DWL and gain accrues to firm
• With perfect price discrimination, there would be no DWL - would all go to monopolist

Note there is still consumer surplus in a monopoly with single price.  But both PS and CS are lower in monopoly than in perfect competition.  Further loss from monopoly is rent seeking - producers spend time/resources trying to make a monopoly

Gains from Monopolies

• Natural Monopoly: Economy where scale benefits are so pronounced that ATC is minimized when only one firm operates
• Given economies of scale, having a second firm would increase ATC significantly
• Economies of scope can also lead to natural monopoly
• Expand product range so ATC decreases
• Regulators might aim to improve resource allocation
• Average Cost Pricing - force monopolist to price where ATC meets demand
• Monopolist gets 'normal' profit
• Marginal Cost Pricing - aka efficient regulation - force monopolist to reduce to where firm MC meets market demand
• This requires a subsidy because now price is below ATC and otherwise firm would leave the market

Problems with regulation

• Lack of information - ATC, MC, market demand unknown
• Cost shifting - firm has no incentive to reduce costs, since regulators will reduce price.  Firm can just allow costs to rise and regulator will allow prices to increase
• Quality - easier to regulate price than quality - firm may reduce quality in a profit squeeze
• Special interest - firm might influence through regulatory board/lobbying

Monopolistic Competition and Oligopoly

Monopolistic Competition

• Large number of independent sellers, each relatively small, no power over price; firms pay attention to average mkt price, not individual competitors' price, and too many firms to collude
• Differentiated products, but close substitutes
• Firms compete on price, quality, and marketing.  Can set price, but usually strong correlation between quality and price you can charge.  Marketing informs about differentiations of products.
• Low barriers to entry - if there are economic profits, firms expected to enter.

Demand curves are highly elastic bc of substitutes.  E.g. toothpaste market.

Oligopoly

• Small number of sellers
• Interdependence among competitors (decisions made by one firm affect the other)
• Significant barriers, often large economies of scale
• Products may be similar OR differentiated

Highly dependent on actions of rivals.  E.g. the automobile mfg market.

Under monop comp, you still go where MR = MC to max profits

• P is greater than MC, so this is inefficient - but remember, there is product diff.
• Question becomes, is there an economically efficient level of product diff
• Efficiency is unclear in monop comp
• Important aspects
• Product innovation - can earn profits, but then subs come in, so must spend more to innovate again - MR of innovation should equal the MC of innovation
• Advertising - expenses are high for monop comp.  Greater than for perfect comp or monopolies.  Increases ATC curve.  But can also increase revenue and might be worth it and decrease ATC. (not sure on this last point - increases profit but doesn't ATC still increase?)
• Brand names - provide signals about quality.  Valuable to firm.

Oligopoly - Kinked Demand Curve Model

• Assumes an increase in product price will not be followed by competitors, but a decrease will
• Each firm believes demand curve is flatter above a given price, and steeper beneath
• Above the kink, firm will lose market share; below, the price decrease cost will swamp the quantity increase benefit
• Thus you should produce at the kink to maximize profit

Oligopoly - Dominant Firm Model (alternative to Kinked Demand model)

• One of the firms has a cost advantage - produces relatively large portion of industry output
• Dominant firm basically acts as a monopolist and others are price takers

Oligopoly Games / Prisoners' Dilemma

• Profit maximized when both firms agree to hold up a higher price - act as a monopoly together
• MR for industry = MC for industry
• If one firm cheats on the agreement, he will make even more but industry profit will not be as high
• If both firms cheat, they are back to the perfect competition result
• Both firms' dominant strategy is to cheat no matter what the other firm does
• Probability of collusion is greater when cheating is easy to detect, when there are fewer firms, when threat of new entrants is lower, and when laws enforcing anti-colluding laws are weaker

End of reading

3:00 pm

1.75 hours

Economics - Micro - Output and Costs

Start 12:30 PM

Output and Costs

Short run and long run

• Short run is where quantities of some resources are fixed
• Technology of production is fixed in short run, thus a constraint
• Labor and raw materials are typically short run
• Decisions easier to reverse
• In long run you can adjust quantities, production methods, plant size
• Once spent, typically a sunk cost

Products of Labor

• Total product - total output of shirts
• Production possibilities frontier - Graph of total product
• Marginal product - number of shirts added by each additional unit of labor
• Decreases as production increases
• Average product - total output divided by total workers
• Average product will max at a point where marginal product intersects it from above
• Usually marginal will start higher than average, then intersect, then lower

Costs

• Total cost = all costs associated with generation of output, fixed + variable
• Total fixed cost - PP&E plus normal profit (value of ability of owners) - independent of firm output
• Total variable cost - increase as output increases - i.e. labor and materials
• Total cost should increase at increasing rate due to increasing marginal cost
• Marginal cost = change in total cost / change in output
• Average cost - fixed, total, or fixed plus total, each divided by number of units

Properties of costs

• AFC (avg fixed cost) decreases
• Vertical distance from ATC to AVC = AFC
• MC declines initially, then increases - first you have scale economies, but then diminishing returns
• MC intersects ATV and AVC at their minimum points
• ATV and AVC are U shaped because diminishing returns set in

Relation between product and cost curve

• MP reaches a max when MC is at a min
• As labor continues to increase, AP reaches a max and AVC reaches a min
• MP is declining and MC is increasing
• After this point, MP and AP both decrease, and MC and AVC both increase

Production function

• This is the relation between inputs (K+L) and quantity produced
• Law of Diminishing Returns - at some point, output continues to increase but at a decreasing rate
• Marginal Product of Capital - increase in output from one additional unit of capital, holding labor constant
• At some point adding capital still increases production but at a decreasing rate

Short Run and Long Run Costs

• Short run curves apply to a plant of a given size
• In long run, even plant size is variable - these curves are called 'planning curves'
• Inherent tradeoff between size of firm and unit costs - unit costs may decline:
• Savings due to mass production
• Specialization of labor/machinery
• Experience
• Long-run average total cost curve is U-shaped
• Economies of scale in first part, diseconomies thereafter
• Diseconomies = bureaucracy, problems motivating large force, principal agent problems, and greater barriers to innovation

End of reading

1:15 pm

0.75 hrs

Economics - Micro - Organizing Production

Start 11:00 AM

Organizing Production

Types of Opportunity Cost/Relation to Economic Profit

Opportunity cost - return a firm's resources could have earned elsewhere in its next most valuable use.  Consists of both explicit and implicit costs

• Explicit - observable, measureable
• Implicit - nonobservable
• Rental Rate - cost to a firm of using its own capital - i.e. it could have given capital to another firm.  Equal to economic depreciation of assets + foregone interest.
• Normal Profit - opportunity cost of owner's entrepreneurship expertise

Economic Profit - considers both explicit and implicit costs

Accounting Profit - only considers explicit costs - it is greater than Economic

Constraints to profit maximization:

• Technology - limited by cost of adopting new production techniques
• Information - information is limited, or if available can be expensive to obtain
• Market - how much customers will pay, and what competitors are doing
• Also resource markets - prices/availability of inputs, investors, etc

Technological Efficiency and Economic Efficiency

• Technological - using least amount of specific inputs to produce a given output
• On an absolute basis, whatever requires less of a given resource is the more technologically efficient
• Economic - producing given output at the lowest cost
• Need to account for input costs
• If something is not technologically efficient, it is also not going to be economically efficient

Command systems and incentive systems and the principal agent problem

• Command - follow a managerial chain of command
• Work better when workers are easier to monitor
• Incentive - system of rewards to encourage workers to act in a way that maximizes profits
• Work when workers are more difficult to monitor
• Many companies have a mix
• Principal Agent Problem
• Incentives/motivations of managers/workers (agents) is not the same as that of owners (principals)
• Essence of the issue is that it is costly for principals to monitor actions of agents
• Can be addressed with giving ownership interests, incentive pay, and long-term contracts (ensure long term success of firm)

Types of business organization

• Proprietorship - single owner, unlimited liability for debts and legal obligations.  Income flows to owner who pays taxes on it as personal income.
• Advantages
• Easy to establish, simple decision process, profits only taxed once
• Disadvantages
• Decisions not checked by group, owner's wealth at risk, business may cease to exist when owner dies, raising capital difficult and expensive
• Partnership - two or more owners, unlimited liability, income allocated based on ownership, taxable as personal income
• Advantages
• Easy to establish, decision with partners, business might survive with second partner, profits only taxed once
• Disadvantages
• Hard to reach consensus, owners' wealth at risk, could be capital shortfall if partner dies.  
• Still hard to raise capital.
• Corporation - owned by stockholders, liability legally limited to amount of money invested in the firm.  Firm is legal entity that pays corporate income taxes.
• Advantages
• Owners have limited liability, more capital readily available, more expertise, life not limited by owners, long-term labor contracts can reduce costs
• Disadvantages
• Complex management, corporate income is taxed twice

Market Concentration

• Markets with a few large firms are more concentrated than markets with many smaller firms
• Four Firm Concentration Ratio
• Percent of total sales made by four largest firms in industry
• Below 40% is considered competitive, above 60% is an oligopoly
• Herfindahl-Hirschman Index (HHI)
• Sum of the squared mkt share percentages of the 50 largest firms (or all firms if less than 50).
• Very low in highly competitive industries, and increases to 10,000 (100^2) for an industry with only one firm
• 1,000 to 1,800 = moderately competitive
• Greater than 1,800 = not competitive
• Limitations of measurements as a degree of competition
• Undefined geographical scope - e.g. newspapers
• Barriers to entry are not captured
• Relationship between market and industry is not always close - same industry does not mean same market (competition); large firms produce many products, all with different levels of competition; firms may switch (similar to barriers to entry argument)

Companies are often more efficient than markets in coordinating activity

• Market coordination - selling through various market channels
• Firm coordination - can be better because it leads to:
• Lower transaction costs
• Economies of scale/scope/team production

End of reading.

11:45 am

0.75 hrs

Economics - Micro - Markets in Action

10:00 AM

Effects of price ceilings, minimum wages, taxes, subsidies, quotas, and trade in illegal goods.

Outside shocks can interrupt supply of goods or services in short run.

Short run = period in which suppliers cannot adjust capacity.

Price ceiling - upper limit on price

• If above eq, no effect; if below, there will be a shortage
• Leads to DWL
• Consumers may have to wait in line (a cost), suppliers may discriminate, take bribes, or reduce quality to a level commensurate with lower price
• Black Market - inefficient because:
• Contracts are not as enforceable
• Risk of prosecution increases prices demanded by supplier
• Quality control deteriorates

Minimum Wage - price floor - lower limit on wage

• If below eq, no effect; if above, there will be excess supply
• DWL on same side as before - Q transacted is lower than efficient quantity
• Consumers substitute away from the good
• Suppliers will devote resources but not be able to sell everything
• Wage floor (binding)
• Firms cannot employ all workers who want to work at that wage
• Firms substitute other productive resources for labor
• Leads to unemployment - even though workers are willing to work for less than minimum wage, they cannot
• Further, firms might decrease quality of nonmonetary compensation

Taxes and their effect on supply/demand/eq

• Tax increases eq price of an object and decreases its quantity demanded
• Tax on suppliers - suppliers reduce supply curve in and left
• Tax on buyers - demand goes in and left
• Vertical distance between old and new supply or demand is the tax
• Whether tax is on buyer or seller, actual incidence of the tax is same
• Tax revenue is rectangle - amount of tax times quantity
• Buyers and sellers share tax burden
• Incidence of tax is allocation of burden between buyers and sellers
• Statutory incedence - who is legally responsible for tax
• Actual incendence - who actually bears the cost of tax
• Statutory on buyer = downward shift in demand curve by the amount of the tax
• Buyer only sees price increase from Pe to Pt - rest of cost is borne by seller
• Seller is punished in form of reduced quantity
• In sum actual tax incidence is independent of whether tax is on consumers or suppliers

  Elasticity and taxes

• Demand
• Inelastic = consumers bear higher burden
• Elastic = consumers bear less burden
• Supply
• Inelastic = suppliers bear higher burden (consumers have the leverage)
• Elastic = suppliers bear less burden
• The party with the more elastic curve can respond better and avoid more of the burden
• More inelastic in either means less DWL
• Fewer trading opportunities are eliminated by the tax

Subsidies - payments by governments to producers

• Results in oversupply - DWL to the right of the efficient point
• MC now exceeds MB
• Supply shifts out (down) by amount of subsidy

Quotas - limits

• Supply and demand stay in place but production lowers - DWL to left
• Producers love quotas - price goes up and MC goes down

Illegal goods

• Supply and demand both decrease to reflect expected penalties
• Decrease in supply or demand increases as the value of the penalty increases
• Penalties higher for suppliers = prices go up
• Penalties higher for buyers = prices go down

End of reading

11:00 AM

1 hour