Finance midterm #2

Required Return

- the return that an investor requires on an asset given its risk.

If a security's standard deviation is high this indicates

A greater uncertainty of the security's return A higher volatility in the security's expected return A greater total risk of the security

What has a beta of zero?

A risk-free asset

What is systematic risk measured by

BETA

Factors that affect systematic risk

Business Cycle Changes A change in tax rate An unexpected change in interest rates

What is typically considered to be a risky security

Common stocks of large companies

Which source of finance typically reduces WACC

Debt

In order to find a value of a firm with FCFE, you would

Discount all FCFE's, sum them up, and add the market value of debt

If you want to value the price per share of a firm's common stock with FCFF, you would

Discount all FCFF's, sum them up, subtract the market value of debt, and then divide by the numbers of shares outstanding

The weakness of using replacement cost method is

Estimating intangible assets

What kind of risk can be diversified away?

Firm-Specific risk is also called diversifiable risk. This risk can be reduced through diversification

Diversification

Investing in more than one security to reduce risk. If two stocks are perfectly positively correlated, diversification has no effect on risk. If two stocks are perfectly negatively correlated, the portfolio can be perfectly diversified.

Why do you have to multiply be one minus tax rate for the cost of debt while you do not for the cost of equity?

It is because bonds create a tax shield to a company.

What is the simplest way for a firm to finance itself?

Keeps earnings as retained earnings

The most expensive source of capital normally is

New common stock

What asset is hard to determine its value?

Patent

Which ratio is often used to value those tech firms during the bubble because of negative earnings

Price-to-sales ratio

T-bill is also what

Risk Free Rate......generally are not susceptible to fluctuations in the market and therefore have a beta of zero

The Security Market Line is a graphical representation of:

The return required given the systematic risk

When you use the discounted cash flow method with free cash flow to the firm to value a company, what discount rate should you use?

Weighted average cost of capital

In what situation would a project add some value to a company?

When firm's return on assets is higher than the project cost of capital. In general, when ROA > Cost of Capital, a project adds value to the firm

The capital structure weights used in computing the weighted average cost of capital are

based on the market value of the firm's debt and equity securities. If available, you always use the market value to calculate the cost of capital.

Names for Market Risk

beta, systematic risk, and non-diversifiable risk

Firm-specific Risk

idiosyncratic risk, non-systematic, can be defined as risk specific to a firm or a handful of firms

Firm A and Firm B are perfectly negatively correlated. If your portfolio contains an equal dollar amount of stock in Firm A and B, what will be the risk of the portfolio?

it will be riskless

A stock with a beta greater than 1.0 has returns that are ____________volatile than the market, and a stock with a beta of less than 1.0 exhibits returns which are ____________volatile than those of the market portfolio.

more, less

Besides long-term debt, what typically reduces WACC?

notes payable

For risk-specific projects, we typically analyze other firms that are already in the new market where we are moving to infer our WACC. This is called a:

pure play

what happens if a firm's beta is 1 or the same as the market

the expected return should be the same as the market... for example..?

The greater the standard deviation.... then the greater?

the greater the uncertainty, and therefore , the greater the RISK.

what happens If the correlation between two stocks is 1

the standard deviation of a portfolio will be weighted average of standard deviations. Therefore, you cannot diversify the unsystematic risk away by combining two stocks and the standard deviation will be the average of two stocks since both are weighed equally.

what happens if CAPM > Holding Period Return

you should sell the stock