Level II Study Plan: Tips and Timeline for CFA Exam Success

1. Results Are Out: What Next? Class Darren Degraaf, CFA, MBA, CPA

2. Spending 400 Hours 1x Is Better than 300 Hours 2x

3. So… You Enjoyed Level I So Much You’re Gonna Write It Again  • Spend more time on PQs this time. • Leave more time for your final review (May  D-Day) • Don’t make the rookie mistake of focusing on your weak areas. • Stick with the higher weightage topics.

4. The Ultimate Study Plan Timeline Jan thru Mar: • Your initial revision should start with a focus on the Wiley Efficient Learning (WEL) “blue box” (BB) examples as you read the WEL Study Guide (SG). • Work the CFA Institute (CFAI) end-of-chapter (EOC) practice questions (PQs). • Grind thru the WEL Test Bank (TB) PQs Apr: • Start to incorporate the CFAI Topic Test (TT) PQs into the rotation. May: • Start your final revision by writing and reviewing the old CFAI mock exams as well as new mocks by the established players. Jun: • Focus on writing and reviewing new CFAI mock(s), as well as reviewing old mocks already written.

5. How Level II Differs from Level I Vignettes can be quite involved with the data you need buried in the text or mixed in a table with irrelevant data. • As you read each vignette, you should circle and/or underline the relevant data that you're going to need. • Making annotations in the margins of the exam booklet also helps; example to follow. The point is to get the relevant data out to where you can get at it without re-reading the vignette three times.

6. Circle’n Annotate

7. Circle’n Annotate Peter Olinto in an analyst looking into a new stock, Degraaf Hairstyling Training (DHT, $14,50). DHT provides seminars on how to improve the appearance of hair at its corporate headquarters in Vancouver. Olinto starts his analysis on July 1, 20X5 and he has gathered the following information: FCFF = NI + I(1-t) + NCC – WC Inv – FC Inv

8. Circle’n Annotate Peter Olinto in an analyst looking into a new stock, Degraaf Hairstyling Training (DHT, $14,50). DHT provides seminars on how to improve the appearance of hair at its corporate headquarters in Vancouver. Olinto starts his analysis on July 1, 20X5 and he has gathered the following information: 26 28

9. How Level II Differs from Level I • Level II is 100% multiple-choice in item set format. • An Item set is a long case or vignette followed by 6 MCQs relating to the case; example to follow. • Because it takes longer to read the item sets, there are only 120 questions on the Level II exam. • Level II emphasizes asset valuation and application of the tools learned at Level I.

10. Calculating FCFF and FCFE When using free cash flows (FCFF or FCFE), a control perspective is taken. The investor can control how cash flows are used; two primary measures of free cash flow: • Free cash flow to the firm (FCFF) -- cash flow available to a firm's capital (equity & debt) suppliers: • Free cash flow to equity (FCFE) is the cash flow available to the common shareholders: • In calculating FCFE, the after-tax cost of debt [INT (1 – t)] is subtracted as interest paid is a cash flow to one of the firm's capital providers (debtholders). For FCFF; no adjustment is required. • Net Borrowing is added back to the FCFE calculation as FCFE is a "post-debt" measure that takes into account the superior claim that debtholders have on a company's free cash flow. • FC Inv = Investment in Fixed Capital, is subtracted from both FCFF and FCFE as these are expenditures necessary for the firm to maintain and grow its operations. • WC Inv – Investment in Working Capital is subtracted for both FCFF and FCFE. Free Cash Flow to the Firm (FCFF) = EBITDA (1 – t) + D(t) – WC Inv – FC Inv Free Cash Flow to Equity (FCFE) = FCFF – INT (1 – t) + Net Borrowing

11. Similarity of Free Cash Flow (FCF) Valuation Models to DDMs & Using the Appropriate Discount Rate Notice the similarity of the constant growth FCF valuation models to the DDM. When using FCFF and FCFE for valuation, the appropriate discount rate is critical. • Since FCFF is the after-tax cash flows accruing to both equity investors and debtholders, the value of a firm is found by discounting FCFF using the weighted-average cost of capital (rWACC). • Since FCFE is the cash flows accruing to common shareholders, it is discounted using the cost of equity (rCE).

12. Choosing Between FCF Valuation Models When choosing between FCFF and FCFE valuation, a key issue is leverage; if the firm has • high leverage, or a • history of leverage changes, then FCFF is better; otherwise, FCFE is preferred. Multistage FCF valuation models: • Similar application to multistage DDMs (as we saw with the constant growth models). • Growth rate can be based on FCFF, FCFE, sales growth (assuming stable margins), or net income. • A three-stage FCF (or DDM) model is appropriate for companies with growth rates that start high (growth stage of life cycle), reach a second stage (shakeout stage) with lower or declining growth, and finally reach a third stage of mature, long-run growth.

13. Comparing FCF Valuation to DDM Valuation FCF models have three advantages over DDMs. • First, FCF valuation can be done even if the firm pays no dividends. • Second, they do not base the valuation of a cash flow that may be unsustainable—DDMs may use dividends that are above or below sustainable levels. (See the CF Reading for the ugly calcs.) • Finally, whether a control perspective is appropriated depends on the valuation's objective. • FCF takes a control perspective, which is good if the firm is a takeover target. • If the goal is to make a minority investment (buy shares, but not control), then the valuation results for FCF models have to be adjusted for the lack of control.

14. Vignette Peter Olinto in an analyst looking into a new stock, Degraaf Hairstyling Training (DHT, $14,50). DHT provides seminars on how to improve the appearance of hair at its corporate headquarters in Vancouver. Olinto starts his analysis on July 1, 20X5 and he has gathered the following information:

15. Vignette • DHT's current growth in earnings, dividends, and free cash flows (FCFE and FCFF) is 8 percent. This rate is only expected to continue for the next two years, and then growth will fall to a long-term rate of 3 percent. • DHT will maintain the current payout ratio. • DHT's beta is 0.9. • DHT's debt was issued and is still trading at par and has a 12 percent coupon. • DHT's capital spending was $20 million in 20X4 and $25 million in 20X5. • Olinto has estimated DHT's cost of equity to be 15 percent and its weighted-average cost of capital (WACC) to be 14 percent. Olinto plans to value DHT using both free cash flow approaches. He has made several adjustments and has projected FCFF and FCFE to be $16 million and $18 million, respectively, for the year ending June 30, 20X6. He believes that DHT will achieve 8 percent growth in 20X7 and then fall to a long-term growth rate of 3 percent. He believes the best approach to finding terminal value is to use the Gordon growth model modified to work with free cash flow.

16. Question DHT's free cash flow to the firm (FCFF) for the year ending June 30, 20X5 is closest to: • $(3.9) million. • $9.1 million. • $13.1 million.

17. Solution Choice "c" is correct. The FCFF is calculated as follows:

18. Incorrect Choices Choice "a" is incorrect. This is the result if the non-cash charges are not added back. Choice "b" is incorrect. This is the result if the working capital change is incorrectly subtracted, instead of added.

19. Tips The key is to find each input for the formula. • The net income (NI) is directly listed on the income statement. • Given the lack of any additional information, the non-cash charges (NCC) solely consist of depreciation expense on the income statement. • The interest expense and tax rate are both on the income statement. • The capital spending, which can also be called investment in fixed capital (FC Inv), is provided in the additional information. • The change in working capital (WC Inv) excludes cash. Other current assets increased $26 million, which is an outflow. The current liabilities increased $28 million, which is an inflow. The net cash flow from working capital is an inflow of $2 million. In essence, the working capital investment was negative $2 million, which when subtracted causes an increase to FCFF. Remember that an increase (decrease) in a current liability is an inflow (outflow) and an increase (decrease) in a current asset (other than cash) is outflow (inflow).

20. Question DHT's free cash flow to equity (FCFE) for the year ending June 30, 20X5 is closest to: • $6.0 million. • $19.0 million. • $23.0 million.

21. Solution Choice "c" is correct. The FCFE is calculated as follows: The firm's long-term debt rose by $12 million, which represents the net borrowing.

22. How the Level III Exam Differs from Level II Time management is key -- • The essay questions are the biggest difference between LII and LIII. • The item sets (afternoon) are the same as you saw at LII. • There are 360 minutes allotted to complete the entire exam (the same as you saw at LI and LII), 3 hours in the morning and 3 hours in the afternoon. • Time management is most critical for the Essay section of the exam because, unlike multiple-choice, if you run out of time, you can't just randomly guess and have any chance at winning some points by luck. • See sample exams on CFA Institute's website under "candidate resources."

23. How the Level III Exam Differs from Level II Note time allotted to each question -- • Note especially the time allotted to each question; i.e., 12 marks = 12 minutes • This is also the point value and will give you some idea of how much you are expected to write in your answer. Use bullet-point format -- • Your answer should be in outline or bullet-point format. • There's no need to write in complete sentences (grammar, style, form doesn't count for or against you), but be careful that you get your point across clearly (make it easy for the grader). Think first, then write -- • Answer in the space/template provided. • Before you begin writing, think for a minute so you don't wind up scratching out large sections (i.e., don't confuse the grader).

24. Types of Essay Questions There are 10-15essay questions (once again, all on the morning paper) and some questions contain a mix of the following two question and answer types: • Short answer  One type asks you to write your answers on the lined page(s) following the question. • Fill in the table  The second type asks you to provide your answers in a template following the question. Each question may have as few as one part or as many as 7-8 parts, so be sure to read and understand the entire question; so, once again… • Note time alotted to each question; • Think first, then write; and • Use bullet-point format

25. Level III CFA Exam Topic Weights • In Ethics, the Recommended Compliance Procedures are more heavily emphasized at LIII than at LI and LII. • Note the most important topic: Portfolio Management.

26. A Typical Passing Grade Report Weightage – Note the topics and the number of points allotted for each essay, particularly thetwo big PM essay questions • Individual, and • Institutional. Item sets – Also note that certain topics are usually tested only in item sets • Ethics, • Derivatives, • Alternative Investments, while others can be tested in either or both sections • Economics, • Equity, • Fixed Income, and • Portfolio Management.

27. Your Target  A Passing Score, not a Perfect Score! According to CFA Institute, no one has ever failed the CFA exam with a score of 70% or better…so that's the target. • That means you can miss at least 108/360 points and still pass! So take heart that you can botch a few questions and still pass, but you must offset those with higher scores in others. You're shooting for a passing score, not a perfect score! • Your strategy should be to maximize your point total (so don’t be distracted by rumours such as minimum scores in Ethics). The report on the next slide might help you prioritize. But, realize that the exam changes from year to year (although it is fairly representative of the last few exam years).