Finance 3101: Exam #2
what are the measures for total risks and systematic risk?
total risk = standard deviation systematic risk = beta
what are the 3 factors cited by Brooks that cause NI to not equal cash flow?
1. accrual accounting 2. non-cash expense items - depreciation 3. preference to classify interest expense as part of financial cash flow
What are the 4 classes of assets Brooks analyses and how do their average returns and standard deviations compare?
3 month treasury bills long tern government bonds large company stocks small company stocks
what is "beta", how is it computed and what is the beta for the market?
B = Returns / Returns market B = 1 ; average market risk B > 1 ; > average market risk B < 1 ; < average market risk
what are the basic guidelines for selecting assets based on the combination of their E(r)s and SDs?
Expected return = E(r) ; y-axis SD; x-axis rational risk adverse- pay less money over more and have less risk
What are HPRs, simple and compounded annual returns and how do you compute them?
Holding period return (HPR) = (profit / loss) / original cost holding period > 1 yr; becomes smaller holding period < 1yr; becomes bigger simple annual return = HPR / n Compound annual return = (1+HPR)^(1/n) - 1
How do stocks differ from bonds with regard to maturities, voting rights, forms of future cash flows and claims against the corporation?
both are financial securities that investors get in exchange for letting a corporation use their funds bonds have a finite period stocks have no finite maturity
What tends to happen initially to a firm's WACC as more debt is used and why?
WACC decreases as debt increases - funds become risker to use as
What is meant by "financial leverage"?
ability that owners have to use other people's money at fixed rates to make higher rates of return that would have been possible by using all of one's own money - main benefit of taking on debt
In the Static Theory of Capital Structure (pp. 514-517 in text) where in the debt-equity ratio is the optimal capital structure?
all debt, not equity - firm is unlevered
what is the balance sheet or accounting identity?
assets = liabilities + OE
What is meant by a bull or bear market; bid-ask spreads; and limited liability?
bull market - widespread significant increases in stock prices; buy stocks bear market - widespread significant decreases in stock prices; sell stocks limited liability - protects shareholders
what is the "CAPM" relationship and what can we use to find it?
capital asset pricing model [CAPM] Re = E (ri) = rf + Bi [E(rm) - rf]
What are the basic parts of the balance sheet?
cash account working capital accounts long term asset accounts
what is the cash flow identity and what does it tell us?
cash flow on the left-hand side of the balance sheet (cash flow from assets) = cash flow on the right-hand side of the balance sheet (cash flow to creditors + cash flow to owners)
what role do correlation coefficients play in the reduction of risk?
correlation coefficient tells you how closely two assets move (i.e., how closely their returns would line up)
what are the forms of future cash flows that investors in stocks might receive?
dividends and what you get when you sell the stock (market value)
what are the four elements needed to appropriately compare alternative investments?
gain or loss original investment annualization (timing) risk
what are the 3 basic types of stock pricing problems?
given future cash flows (formula 30) preferred stock - present value of perpetuity (formula 31) constant dividend growth (formula 32 & 33)
ceteris paribus, how does the (constant) dividend growth rate affect. a stock's market price?
if the constant dividend growth rate goes up, it will make the stocks increase
Bid & Ask prices: What pays which price in the transaction between investors and dealers?
investors buy and sell stock through dealers dealers have prices they are willing to buy and prices they are willing to sell ask price > bid price investor buys at ask price and sells at bid price
what are the basic parts of the income statement?
net income = revenues - expenses EBIT = revenues - operating expenses
why do we focus on cash flow rather than NI in finance?
net income is not the same as cash flow ex. firm earned income $5,642M; cash account decreased by $65M
what is the rule for selecting assets based on their reward-to-risk ratios?
pick the asset with the highest reward-to-risk ratio
what are the "reward" and "risk" in the reward-to-risk ratio and how is this ratio related to question #1 above?
reward-to-risk ratio = [(E(ri)-rf)/Bi] select stock with highest ratio
what is meant by a "risk premium" and how is it computed?
risk premium - [Expected return on asset/stock - risk free rate] rewards investors for taking on risk
what is the relationship between the standard deviation and the degree of risk?
same mean; higher standard deviation = higher risk
What are the implications of Brooks' findings in the preceding questions?
the least amount of confidence in a predicted return on an asset type with a higher standard deviation and vice versa
What is the meaning of unsystematic and systematic risk and by what other names are these risks known?
total risk = unsystematic + systematic risk unsystematic is also known as: unique, company specific, diversifiable systemic risk also known as: nondiversifiable, market risk
which type of risk can be eliminated and by what process?
unsystematic risk can be eliminated by diversification
How is a firm's cost of capital computed; what does "WACC" stand for?
weighted average cost of capital
