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Total periodic pension cost represents…

…the true cost of the pension. If the firm’s contributions exceed its true pension expense, the difference can be viewed as a reduction in the overall pension obligation similar to an excess principal payments on a loan.

CFO increases by contributions – TPPC

CFF decreases by contributions – TPPC

The steps to calculate duration of a callable bond.

  1. Given assumptions about benchmark interest rates, interest rate volatility, and call or put rule, calculate OAS using binomial model.
  2. Impose a small shift in the on-the-run yield curve +Δy
  3. Build a new binomial tree using the new yield curve
  4. Add OAS to each 1-year forward rate to get a “modified” tree.
  5. Compute BV+Δy using modified tree
  6. Repeat steps 2 through 5 using a parallel rate shift of -Δy to estimate value of BV-Δy

Information Ratio ex-ante VS ex-post

ex-ante IR is anticipated residual return adjusted for risk. It is always positive.

ex-post IR is realized past residual return adjusted for risk.

ex-post IR = tα/√n = t-stat of intercept / square root of # of observations

Merger arbitrage strategy is comparable to:

Selling Insurance

The investor makes a small profit if the merger is successful but may incur a large loss if it fails.

There are two ways to correct for serial correlation in regression residuals:

  1. Adjust the coefficient standard errors to account for serial correlation using Hansen’s Method which will also correct for heteroskedasticity.
  2. Modify the regression equation to eliminate serial correlation.

Will increasing invested capital to take advantage of projects with positive NPV increase EVA or NOPAT?

Yes, both.

Increasing invested capital to take advantage of positive NPV projects will increase NOPAT and the dollar cost of capital $WACC. Because NPV is positive the increase in NOPAT will be larger than the increase in $WACC so EVA will increase.

Altman Z-Score Interpretation

A score below 1.8 implies the company is headed for bankruptcy.

A score above 3.0 implies the company is not likely to go bankrupt.

A score between 1.8 and 3.0 is inconclusive but traders may purchase a stock when its Altman Z-score approaches 3.0 and short a stock when its Altman Z-score approaches 1.8

Summary of the Beneish Model

A mathematical model that uses 8 variables to identify whether a company has manipulated earnings.

The 8 variables are:

  • Day’s Sales in Receivable Index
  • Gross Margin Index
  • Asset Qualities Index
  • Sales Growth Index
  • Depreciation Index
  • SG&A Index
  • Leverage Index
  • Total Accruals to Total Assets

M-Score > -2.22 implies manipulation.

Credit Enhancements

Internal Credit Enhancements

  • Cash Reserve Account
  • Excess Servicing Spread Accounts
  • Overcollateralization
  • Senior/Subordinate Structure

External Credit Enhancements

  • Letters of Credit
  • Bond Insurance

Dividends on the underlying stock ____ the value of call options and ____ the value of put options.

Dividends decrease the value of a call and increase the value of a put.