Finance

Chapter 11: You would like to create a portfolio that is equally invested in a risk-free asset and two stocks. One stock has a beta of 1.14. What does the beta of the second stock have to be if you want the portfolio to be equally as risky as the overall market?

(1/3)(1.14)+(1/3)X+(1/3)(0) = 1

Problems with scenario analysis

-Considers only a few possible out-comes -Assumes perfectly correlated inputs -All "bad" values occur together and all "good" values occur together -Focuses on stand-alone risk, although subjective -adjustments can be made

Weaknesses of Sensitivity analysis

-Does not reflect diversification. -Says nothing about the likelihood of change in a variable, -Ignores relationships among variables

You SHOULD include

-Opportunity costs: Cost of lost loans options. Negative effects: Costs to other projects Positive effects: Benefits to other projects

Strengths of Sensitivity Analysis

-Provides indication of stand-alone risk. -Identifies dangerous variables. -Gives some breakeven information.

Risk Premiums

-Return greater than the risk-free rate -"extra" return earned for taking on a risk

Sensitivity analysis

-Shows how changes in an input variable affect NPV or IRR -Each variable is fixed except one Change one variable to see the effect on NPV or IRR -Answers "what if" questions

Do NOT include these types of cash flows

-Sunk Costs: costs that have accrued in the past - usually are not a relevant cash flow -Financing costs: not a relevant cash flow, as is handled in the discounting

Stand-Alone Principle

-The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows -Once we identify the effect of undertaking the proposed project on the firm's cash flows, we need only focus on the project's resulting incremental cash flows. (Also Stand-Alone Risk)

Chapter 10: Home Grown Grains stock returned 28.7%, 2.6%, 13.1%, and 11.8% over the past four years. What is the arithmetic average for this period?

28.7+2.6+13.1+11.8/4= 14.05%

Chapter 10: One year ago, you purchased 400 shares of stock for $12 a share. The stock pays $.22 a share in dividends each year. Today, you sold your shares for $28.30 a share. What is your total dollar return on this investment?

Amount sold stocks for-amount per share+what the stock pays (28.30-12+0.22)x400 = $6,608

Chapter 12: The general store has a cost of equity of 15.8%, a pre-tax cost of debt of 7.7%, and a tax rate of 32%. What is the firm's weighted average cost of capital if the debt-equity ratio is 0.40?

D/E = 0.4 = .4/1 v=1.4 WACC=(1/1.4)(.158)+(.4/1.14)(.077)(.68) = 12.78%

Chapter 9: A project has sales of $462,000, costs of $274,000, depreciation of $28,000, interest expense of $3,400, and a tax rate of 35%. What is the value of the depreciation tax shield?

Depreciation x Tax rate= 28,000x.35 = 9,800

Chapter 11: A stock has a beta of 1.37 and an expected return of 16.6%. The risk-free rate is 4.8%. What is the slope of the security market line?

E(r)-Rf/Beta .166-.048/1.37 = .086

After Tax salvage value

If the actual selling price of the used equipment is different from the book value of the asset, then there is a tax effect.

Geometric Average

Most accurately reflects your true holding period return

Disadvantages of Both Sensitivity and Scenario Analysis

NEITHER PROVIDES A DECISION RULE No indication whether a project's expected return is sufficient to compensate for its risk. IGNORES DIVERSIFICATION Measures only stand-alone risk, which may not be the most relevant risk in capital budgeting.

Chapter 9: A debt-free firm has net income of $128,400, taxes of $46,200, and depreciation of $21,300. What is the operating cash flow?

Net income + Depreciation (if no interest) 128,400 + 21,300

Chapter 12: Hi Tech Products has 35,000 bonds outstanding that are currently quoted at 102.3. THe bonds mature in 11 years and carry a 9% annual coupon. What is the firm's after-tax cost of debt if the applicable tax rate is 35%?

PMT=90 n=11 FV=1,000 PV=-102.3 i/y=9 CPT YTM= 8.67 After tax Rd= (8.67)(1-.35)= 5.63%

Chapter 12: Judy's boutique just paid an annual dividend of $1.65 on its common stock. The firm increases its dividend by 2.5% annually. What is the rate of return on this stock if the current stock price is $38.20 a share?

Re=(1.65)(1.025)/38.20 + .025 = 6.9%

Chapter 12: The common stock of Modern Interiors has a beta of 1.61 and a standard deviation of 27.4%. The market rate of return is 13.2% and the risk-free rate is 4.8%. What is the cost of equity for this firm?

Re=0.048+[.132-.048] (1.61)=18.3% (CAPM)

Chapter 12: You are given the following information concerning Parrothead Enterprise: 8,300 shares of 4.65% preferred stock selling at $94.30 per share. What is the cost of preferred stock Rp?

Rp= 4.65/94.30 = .0493 = 4.93% (Assume par value = 100 is not specified)

The principle of diversification

Spreading an investment across a number of assets will eliminate some, but not all, of the risk.

Forms of Market Efficiency

Strong-form Efficient Market: -->Information = Public or private "Inside information" is of little use -->Semistrong-form Efficient Market: Information = publicly available information Fundamental analysis is of little use -->Weak-form Efficient Market: Information = past prices and volume data Technical analysis is of little use

Systematic Risk

Systematic Risk involves factors that affect a large number of assets "Non-diversifiable risk" "Market risk" Examples: changes in GDP, inflation, interest rates, etc.

Incremented cash flows

The cash flows that should be included in a capital budgeting analysis are those that will occur only if the project is accepted

Systematic risk principle

The expected return (market required return) on an asset depends only on that asset's systematic or market -The higher the beta, the risk premium

Unsystematic Risk

Unsystematic risk = Diversifiable risk Risk factors that affect a limited number of assets Risk that can be eliminated by combining assets into portfolios "Unique risk" "Asset-specific risk"

Chapter 10: Your portfolio has provided you with returns of 8.6%, 14.2%, -3.7%, and 11.4%. What is the geometric average return for this period?

[(1.086)(1.142)(0.963)(1.114)]^1/4-1= 7.4%