FIN 300: Ch. 11 & 12 Review

The SML is a graphical depiction of _______

CAPM

The symbol ___ stands for the market value of the firm's debt

D

How do you calculate the variances of the returns on two stocks?

To calculate the variances of the returns on our two stocks, we first determine the squared deviations from the expected returns. We then multiply each possible squared deviation by it probability. We add these, and the result is the variance. The standard deviation is the square root of the variance

The symbol ____ stands are the market value of the firm's equity

E

Under SML, we can write the expected return on the company's equity, E(Re) as

E(Re) = Rf + Be x [E(Rm) - Rf]

SML slope

E(Ri) = Rf + [E(Rm) - Rf] x βi

Market risk premium

E(Rm) - Rf

Suppose we had n assets in our portfolio, where n is any number. If we let xi stand for the percentage of our money in Asset i, then the expected return is

E(Rp) = x1 *E(R1) + x2 * E(R2) + ... + xn * E(Rn) This says that the expected return on a portfolio is a straightforward combination of the expected returns on the assets in that portfolio

Problem with WACC: corporations with more than one line of business

Ex. corporation has 2 divisions regulated electric company (lower risk) and an electronics manufacturing operation (high risk) o Firm's overall cost of capital is a mixture of two costs of capital o If the two divisions were competing for resources and the firm used a single WACC as a cutoff the riskier division would tend to have greater returns (ignoring the greater risk) o Solution is to develop separate divisional costs of capital

Equation for CAPM

Expected return on security = riskfree rate + beta x (return on market - riskfree rate)

Summary of risk & return concepts

Total return: the total return on an investment has two components: the expected return and the unexpected return *The unexpected return comes about because of unanticipated events *The risk from investing stems from the possibility of an unanticipated event Total risk: the total risk of an investment is measured by the variance, or, more commonly, the standard deviation of its return Systematic and unsystematic risks: *Systematic risks (also called market risks) are unanticipated events that affect almost all assets to some degree because the effects are economywide *Unsystematic risks are unanticipated events that affect single assets or small groups of assets *Unsystematic risks are also called unique or asset-specific risks The effect of diversification *Some, but not all, of the risk associated with a risky investment can be eliminated by diversification *Unsystematic risks, which are unique to individual assets, tend to wash out in a large portfolio, but systematic risks, which affect all of the assets in a portfolio to some extent, do not The systematic risk principle and beta *Because unsystematic risk can be freely eliminated by diversification, the systematic risk principle states that the reward for bearing risk depends only on the level of systematic risk *The level of systematic risk in a particular asset, relative to the average, is given by the beta of that asset The reward-to-risk ratio and the security market line *The reward-to-risk ratio for Asset i is the ratio of its risk premium, E(Ri - Rf), to its beta βi: · E(Ri) - Rf / βi *In a well-functioning market, this ratio is the same for every asset *When assets expected returns are plotted against betas, all assets plot on the same straight line, called the security market line (SML) The capital asset pricing model *Form the SML, the expected return on Asset i can be written: · E(Ri) = Rf + [E(Rm) - Rf] x βi *CAPM- the expected return on a risky asset thus has 3 components: · 1. The pure time value of money, Rf · 2. The market risk premium, [E(Rm) - Rf] · 3. Beta for that asset, βi

The symbol ___ (for value) stands for the combined market value of debt and equity

V

V equation

V = E + D 100% = E/V + D/v These percentages can be interpreted like portfolio weights, and they often are called the capital structure weights

WACC formula

WACC = (E/V) x Re + (D/V) x Rd x (1-Tc)

WACC formula with preferred stock

WACC = (E/V) x Re + (P/V) x Rp + (D/V) x Rd x (1-Tc)

Pure play

a company that focuses only on a single line of business

If we are determining the discount rate appropriate to aftertax cash flows, then the discount rate also needs to be expressed on an _______ basis

aftertax

In profile management terms, the distance between a portfolio's actual return and the SML is often called ________

alpha

Overvalued

an asset is said to be overvalued if its price is too high given its expected return and risk

At a minimum, any new investment our firm undertakes must offer what?

an expected return that is no worse than what the financial market offers for the same risk

Which terms mean the same things as required return?

appropriate discount rate & cost of capital

Is there a reward for bearing unsystematic risk?

because unsystematic risk can be eliminated at virtually no cost (by diversifying) there is no reward for bearing it (the market does not reward risks that are borne unnecessarily)

______ tells us the amount of systematic risk of an asset or portfolio relative to the risk-free asset

beta

How is D calculated?

by multiplying the market price of a single bond by the number of bonds outstanding

How is E calculated?

by taking the number of shares outstanding and multiplying it by the price per share

Dividends paid to common stockholders _______ be deducted from the payer's taxable income for tax purposes

cannot

Dividend growth model is only applicable to companies that pay dividends and dividends are growing at a ______ _______

constant rate

To create a portfolio of stocks, you must invest in stocks of more than one ________

corporation

The return an investor in a security receives is the _______ of that security to the company that issued it

cost

Given that a firm uses both debt and equity capital, this overall ______ ____ ______ will be a mixture of the returns needed to compensate its creditors and its stockholders

cost of capital

The appropriate discount rate on a new project is the minimum expected rate of return an investment must offer to be attractive. This minimum required return often is called the _____ ____ _____ associated with the investment

cost of capital

The appropriate discount rate to use to evaluate a new project is the _______ __ _______

cost of capital

To calculate a firm's overall _____ _____ ______, we multiply the capital structure weights by the associated costs and add the pieces

cost of capital *the result is the weighted average cost of capital, or WACC

The rate used to discount projected cash flows

cost of capital, discount rate, required return

Tax-deductible to the firm

coupon interest paid on bonds

A firm's cost of capital will reflect both its cost of ______ capital and its cost of ______ capital

debt, equity

Risk premium

difference between the return on a risky investment and that on a risk-free investment

The ________ rate for the firm's projects equals the cost of capital for the firm as a whole when all projects have the same risk as that of the firm overall

discount

If a firm has multiple projects, each project should be discounted using a _____ ______commensurate with the project's risk

discount rate

The firm's WACC is the appropriate ______ _______ only if the proposed investment is a replica of the firm's existing operating activities

discount rate

A common way of saying that an announcement isn't news is to say that the market has already "__________" the announcement

discounted When we say that we discount an announcement, or a news item, we mean that it has less of an impact on the market because the market already knew much of it

Some risk is ________ and some is not

diversifiable

Unsystematic risk is essentially eliminated by _________, so a relatively large portfolio has almost no unsystematic risk

diversification

The benefit in terms of risk reduction from adding securities _______ _____ as we add more

drops off

The principle of diversification tells us that spreading an investment across many assets will ________ some of the risk

eliminate

Using the WACC as the discount rate for future cash flows is only appropriate when the proposed investment is similar to the firm's _______ ________

existing activities o Ex. if we were in the pizza business, and thinking of opening a new location, the WACC would be the discount rate to use

Announcement = _________ part + surprise

expected The expected part of any announcement is the part of the information that the market uses to form the expectation, E(R), of the return on the stock. The surprise is the news that influences the unanticipated return on the stock, U

The _______ _______ of a portfolio is a combination of the weights of each asset in a portfolio

expected return

Total return formula

expected return + unexpected return R = E(R) + U

Risk premium formula

expected return - risk-free rate E(Ru) - Rf

The cost of capital depends primarily on the use of ____, not the source

funds

To determine whether or not an investment has a positive NPV, we essentially compare the expected return on that new investment to what the financial market offers on an investment with the same beta. This is why the SML is so important; it tells us the "______ ______" for bearing risk in the economy

going rate

Assume all projects fall into one of these classes

high risk, moderate risk, low risk, mandatory

How do you get a portfolio's beta?

if we had a large number of assets in a portfolio, we would multiply each asset's beta by its portfolio weight and then add the results to get the portfolio's beta

Standard deviation _________ as the number of securities is _________

increased

CAPM works for portfolios of assets along with _______________ assets

individual

The ________ paid by a corporation is deductible for tax purposes, but payments to stockholders, such as dividends, are not (the government pays some of the interest)

interest

Portfolio weights

list of the percentages of the total portfolio's value that are invested in each portfolio's asset

Based on CAPM, the slope of the SML is equal to the _______ ______ ____, [E(Rm) - Rf]

market risk premium

An investment will have a _________ NPV when its expected return is less than what the financial markets offer for the same risk

negative

Returns depend on _____ information

new

Can systematic risk be eliminated by diversification?

no- a systematic risk affects almost all assets to some degree

There is a minimum level of risk that cannot by eliminated by diversifying --> _______________ risk

non-diversifiable

Systematic risk = ___________ risk

non-diversifiable risk

The expected return on an asset depends on what?

only on that asset's systematic risk

Diversification reduces risk, but _________________

only up to a point

Preferred stock has a fixed dividend paid every period forever, so a share of preferred stock is essentially a __________

perpetuity

When we are evaluating investments with risks that are substantially different from those of the overall firm, the use of the WACC will potentially lead to ______ decisions

poor

Most investors hold a ___________ of assets

portfolio (more than just one single stock, bond, or other asset)

a portfolio beta can be calculated like a _________ __________ _______

portfolio expected return

Some of the riskiness associated with individual assets can be eliminated by forming _______

portfolios

A _________ alpha means that the asset (or portfolio) has earned a return in excess of what it should earn based on its beta

positive

The SML shows that the relationship between a security's expected return and its beta is ______

positive

When we say that the required return on an investment is 10 percent --> the investment will have a ________ NPV only if its return exceeds 10 percent (firm must earn 10% on the investment to compensate its investors for the use of capital needed to finance the project) 10% is the _______ ____ _______ associated with the investment

positive, cost of capital

SML

relationship between the expected return on a security and its systematic risk

Dividend growth model does not really explicitly consider _______

risk

The SML adjusts for _______ and is applicable to companies other than those with steady dividend growth

risk

The WACC for a firm reflects the _____ and the target capital structure of the firm's existing assets as a whole

risk

The cost of capital associated with an investment depends on the ________ of that investment

risk

A firm that uses its WACC to evaluate all projects will have a tendency to both accept unprofitable investments and become increasingly _____

risky

Unsystematic risk

second type of surprise, that affects a single asset or a small group of assets *because these risks are unique to individual companies or assets, they are sometimes called unique or asset-specific risks

The estimated cost of equity is very ________ to the estimated growth rate

sensitive

If there is debt that is not publicly traded, we must observe the yield on what?

similar, publicly traded debt and then estimate the market value of the privately held debt using this yield as the discount rate

What is the primary advantage of the dividend growth model

simplicity

An unsystematic risk is one that is particular to a ______ _____ or at most, a small group

single asset Ex. if the asset under consideration is stock in a single company, the discovery of positive NPV projects such as successful new products and innovative cost savings will tend to increase the value of the stock Unanticipated lawsuits, industrial accidents, strikes and similar events will tend to decrease future cash flows and thereby reduce share values

Standard deviation is the _________ of variance

square root

Systematic risk principle

states that the reward for bearing risk depends only on the systematic risk of an investment

Because of the difficulties that exist in objectively establishing discount rates for individual projects, firms often adopt an approach that involves making ________ adjustments to the overall WACC

subjective

Total risk = __________ risk + ___________ risk

systematic + unsystematic

Unexpected return is broken into what?

systematic and unsystematic R = E(R) + systematic portion + unsystematic portion m = systematic (stands for market) ε=unsystematic R = E(R) + U R = E(R) + m + ε

If an asset has a reward-to-risk ratio of 6.0%, that means it has a risk premium of 6.0% per unit of _______ ________

systematic risk

Beta coefficient (β)

tells us how much systematic risk a particular asset has relative to an average asset

Ex. of unsystematic risks

the announcement of an oil strike by a company *will affect the company and perhaps a few others (primary competitors and suppliers) but it is unlikely to have much of an effect on the world oil market, or on the affairs of companies not in the oil business

The only way we benefit our shareholders is by finding investments with expected returns that are superior to what the financial markets offer for the same risk. Such an investment will have a positive _______

NPV (net present value)

Innovation / surprise

the difference between the actual result and the forecast

Expected risk premium

the difference between the expected return on a risky investment and the certain return on a risk-free investment

Capital Asset Pricing Model (CAPM)

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

The expected return on a portfolio is a combination of what?

the expected returns on the assets in the portfolio

Systematic risk

the first type of surprise, the one that affects a large number of assets *because systematic risks have market-wide effects, they are sometimes called market risks

Security market line (SML)

the line that results when we plot expected returns and beta coefficients, describes the relationship between systematic risk and expected return in financial markets

The SML approach requires that two things be estimated

the market risk premium, the beta coefficient

What is the WACC

the overall return the firm must earn on its existing assets to maintain the value of its stock

Diversification

the process of spreading an investment across assets (and thereby forming a portfolio)

The SML approach

the required or expected return on a risky investment depends on 3 things: 1. the risk free rate, Rf 2. the market risk premium, E(Rm) - Rf 3. the systematic risk of the asset relative to that in an average risky asset (beta coefficient, β)

What does the SML tell us?

the reward for bearing risk in financial markets

True risk of investment

the unanticipated part of the return, the portion resulting from surprises

Project's discount rates should reflect what?

their particular level of risk

Pure play approach

try to find companies that focus as exclusively as possible on the type of project in which we are interested to estimate the required return on an investment

The true risk of any investment comes from what?

unanticipated events and surprises

Ex. of systematic risks

uncertainties about general economic conditions: -GDP -interest rates (affects wages and the costs of the supplies that companies buy, it affects the value of the assets that companies own; and it affects the prices at which the companies sell their products) -inflation *these conditions affect nearly all companies to some degree

Dividend growth model approach

under the assumption that the firm's dividend will grow at a constant rate, g, the price per share of the stock, Po can be written as: Po = D1/Re - g Re = required return on the stock Re = D1/Po + g *because Re is the return that the shareholders require on the stock, it can be interpreted as the firm's cost of equity capital

Diversifiable risk = ___________ risk

unsystematic

For a well diversified portfolio, the _________ risk is negligible, essentially all the risk is _________

unsystematic, systematic

_________ is a measure of the squared deviations of a security's return from its expected return

variance

When we combine assets into portfolios, the unique or unsystematic events, both positive and negative, tend to "_____ _____" once we have more than a few assets

wash out

What is the appropriate discount rate?

we should use the expected return offered in financial markets on investments with the same systematic risk

Portfolio ________ can be defined as the percentage of dollars invested in each asset

weights

Can unsystematic risk be eliminated by diversifying?

yes

Does the reward-to-risk ratio have to be the same for all the assets in the market?

yes

Unlike a firm's cost of equity, its cost of debt normally can be observed either directly or indirectly because the cost of debt is the interest rate the firm must pay on new borrowing, and we can observe interest rates in the financial markets. For example, if the firm already has bonds outstanding, then the _____ ___ ________ on those bonds is the market-required rate on the firm's debt

yield to maturity

True about a firm's cost of debt

yields can be calculated from observable data it is easier to estimate than the cost of equity

Aftertax rate that is used for the cost of debt can be written as

RD x (1-Tc)

What are the two possible states of the economy?

Recession or boom

What is the cost of preferred stock

Rp = D/Po

To determine the appropriate required return for an investment, we can use the ______

SML

What is the slope of the line on portfolio expected returns and betas?

Slope = E(Ra) - Rf / β *this is the reward to risk ratio

Ex. if we have $50 in one asset and $150 in another, then our total portfolio is worth ________ The percentage of our portfolio in the first asset is $50/$200 = _____ and the percentage of our portfolio in the second asset is $150/$200 = _____ Adds up to _____

$200, .25, .75, 1.00

Unsystematic risk other names

-diversifiable risk -unique risk -asset-specific risk

Systematic risk other names

-non-diversifiable risk -market risk

Two approaches to determining the cost of equity

-the dividend growth model approach -the security market line (SML) approach

What is the beta of a risk free asset?

0

An asset with a beta of _____, therefore, has half as much systematic risk as an average asset; and an asset with a beta of ______ has twice as much

0.50, 2.0

Summary of capital cost calculations

1. The cost of equity, Re A. dividend growth model approach: · Re = D1/Po + g · D1 is the expected dividend in one period · g is the dividend growth rate · Po is the current stock price B. SML approach · Re = Rf + βe x (Rm - Rf) · Rf is the risk-free rate · Rm is the expected return on the overall market, βe is the systematic risk of equity 2. The cost of debt, Rd A. for a firm with publicly held debt, the cost of debt can be measured as the yield to maturity on the outstanding debt. The coupon rate is irrelevant B. if the firm has no publicly traded debt, then the cost of debt can be measured as the yield to maturity on similarly rated bonds 3. The weighted average cost of capital, WACC A. the firm's WACC is the overall required return on the firm as a whole. It is the appropriate discount rate to use for cash flows similar in risk to the overall firm B. the WACC is calculated as: · WACC = (E/V) x Re + (D/V) x Rd x (1-Tc) · Tc is the corporate tax rate · E is the market value of the firm's equity, D is the market value of the firm's debt, and V = E + D · E/V is the percentage of the firm's financing (in market value terms) that is equity and D/V is the percentage that is debt

Return on any stock traded in a financial market is composed of two parts

1. the normal or expected return from the stock is part of the return that the shareholders in the market predict or expect 2. uncertain, risky, part - comes from the unexpected information revealed within the year ex. news about research on Flyers, Government figures released on gross domestic product (GDP), the results from the latest arms control talks, the news that Flyers's sales figures are higher than expected, a sudden, unexpected drop in interest rates

The CAPM shows that the expected return for a particular asset depends on 3 things

1. the pure time value of money (As measured by the risk-free rate, Rf, this is the reward for merely waiting for your money, without taking any risk) 2. the reward for bearing systematic risk (As measured by the market risk premium, [E(Rm) - Rf], this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting) 3. the amount of systematic risk (As measured by βi, this is the amount of systematic risk present in a particular asset, relative to an average asset)

To use the dividend growth rate model, must come up with an estimate for g

1. use historical growth rates 2. use analysts' forecasts of future growth rates

An average asset has a beta of ______ relative to itself

1.0

The benefit in terms of risk reduction from adding securities drops off as we add more and more *By the time we have _____ securities, most of the effect is already realized, and by the time we get to 20 or so, there is very little remaining benefit

10

Ex. for stocks L and U, with portfolio weights .50 and .50, if the economy enters a recession, half of your money (the half in L) loses 20% and the other half in U gains 30% Rp = .50 x -20% + .50 x 30% = _____ When a boom occurs: Rp = .50 x 70% + .50 x 10% = 40% What is the E(rp)? _______ Calculated by: .50 x 5% = 2.5% .50 x 40% = 20% E(Rp) = 22.5%

5%, 22.5%