Finance Learnsmart Chapter 11

WACC with preferred stock

(P/V) x R(P)

Unsystematic Risk will affect?

1. A specific Firm 2. Firms in a single industry

Examples of information that may impact the risky return of a stock?

1. An outcome of an application currently pending with the Food and Drug Administration 2. The Fed's decision of interest rates in their meeting next week

The four steps of computing Variance?

1. Calculate the expected return 2. Calculate the deviation of each return from the expected return 3. Square each deviation 4. Calculate the average squared deviation

What is the expected return of a security with a beta of 1.2 if the risk-free rate of 4% and the expected return on the market is 12%?

13.6%

ABC has a beta of 2.5 and XYZ has a beta of 1.5. The risk-free rate is 4% and the market premium risk is 9%. What is the expected return on a portfolio that is equally invested in both?

B= (2.5+1.5)/2= 2 Expected Return=4%+ 2(9%)= 22%

WACC(Weighted Average Cost of Capital) is used to discount?

Cash

The minimum required return on a new project is called?

Cost of Capital

Components of WACC

Cost of preferred stock, Cost of debt, Cast of common stock

------------ is reduced as more securities are added to the portfolio.

Diversifiable Unsystematic Company Specific

The systematic risk principle argues that the market does not reward risks that are:

Diversifiable or Borne unnecessarily

Reward to Risk ratio formula?

E(R1)-R2 /B(change in beta)

Equation for the Capital Asset Pricing Model

Expected return on Security= Risk-free rate + Beta (Return on Market - Risk-free Rate)

What is an uncertain or risky return?

It is the portion of returns that depends on information that is currently unknown,

What is the definition of Expected Return?

It is the return an investor expects to earn on a risky asset in the future

As more securities are added to a portfolio, what will happen to its unsystematic risk?

It will decline and possibly be eliminated totally

A security has a beta of 1, a market risk premium of 8%, and a risk-free rate of 3%. What will happen to the expected return if the beta doubles?

Old: 3%+ 1 x 8% = 11% New: 3% + 2 x 8% = 19% Expected Return increases from 11% to 19%

If security ABC has a beta of 1.5 and security XYZ has a beta of 1, what is the beta of a that is equally invested in both securities?

Portfolio beta: 0.5 x 1.5 + 0.5 x 1 = 1.25

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

Risk Premium; Systematic Risk

What is the square root of Variance?

Standard Deviation

Beta tells us the amount of ---------- risk of an asset or portfolio relative to -----------.

Systematic; an average risky asset.

What will happen to the firm if over time they use their overall WACC to evaluate projects, regardless of risk level?

The firm overall become riskier. It will reject projects it should have accepted and accept projects it should reject.

WACC is the minimum required return for?

The overall firm

What is the intercept of the security market line (SML)?

The risk free-rate

According to the Capital Asset Pricing Model (CAPM), what is the expected return of a security with a beta of 0?

The risk-free rate of return

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

Variance

What is a portfolio?

When you already have money invested in stocks

Systematic risk is also called ----------- risk.

market

When an investor is diversified, only --------- risk matters

systematic

For a firm with outstanding debt, the cost of debt will be the -------------------- on that debt.

yield to maturity