Finance exam 4

When using economic probabilities to compute the expected return on a stock, the result is:

a mathematical expectation based on a weighted average and not a guaranteed outcome.

risk premium

expected return - risk free rate

Principle of diversification

implies some of the riskiness with individual assets can be eliminated by forming portfolios

systematic risk

influences many assets (e.g., uncertainties about general economic conditions, such as GDP, interest rates, or inflation)

security market line (SML)

is a positively sloped, straight line displaying the relationship between expected return and beta

portfolio weights

percentages of a portfolio's total value invested in a particular asset

float

the difference between book cash and bank cash

Capital asset pricing model (CAPM)

the equation of the SML showing the relationship between expected return and beta

Systematic risk principle

the expected return on a risky asset depends only on that asset's systematic risk

Expected return

the return on a risky asset expected in the future

To determine a firm's cost of capital, one must include:

the returns currently required by both debtholders and stockholders.

The expected return on a stock given various states of the economy is equal to the

weighted average of the returns for each economic state

The expected return of a stock, based on the likelihood of various economic outcomes, equals the:

weighted average of the returns for each economic state.

A firm's pretax cost of debt

It is based on the current yield to maturity of the company's outstanding bonds.

weighted average cost of capital (WACC)

To calculate the firm's overall cost of capital, we multiply the capital structure weights by the associated costs and add them up

systematic risk is measured by

a beta of 1.0

unsytematic risk

is a risk that affects at most a small number of assets (e.g., the announcement of an oil strike by a company)

Cost of equity

the return that equity investors require on their investment in the firm

Cost of debt

the return that lenders require on the firm's debt