HB 311 1st Edition Exam 3 Study Guide Chapter 9 1 Understand general relationship between risk and return pg 370 372 a The general idea behind risk and return is that higher financial rewards returns come with higher risks To understand this first we have to define the risk in a measurable way and then relate that measurement to return according to some formula that can be written down 2 Understand expected and required returns 372 a Expected Return the return the investors feel is most likely to occur based on available information The mean of the distribution of the returns is also the expected return b Required Returns minimum rate at which investors will purchase or hold a stock based on their perceptions of its risk 3 What is the definition of risk pg 372 373 a Risk Probability that return will be less than expected 4 Understand portfolio theory and systematic and unsystematic risk a Portfolio theory Attempts to either maximize expected returns or minimize risk for a given level of expected return by carefully choosing proportions of various assets b Systematic Risk Is the risk of collapse in a market Financial Crisis of 2008 c Unsystematic Risk Uncertainty that comes with the company or industry invested in 5 Understand the concept of standard deviation and beta a Standard Deviation annual rate of return of an investment to measure the investment s volatility b Beta Represents an average based on past history 6 Understand capital asset pricing model CAPM a Capital Asset Pricing Model CAPM Attempts to explain stock prices by explaining how investors required returns are determined 7 Know how to calculate a Expected return Mean of each distribution b Standard deviation as a measure of risk measure of spread of the numbers in a set of data from its mean value c Beta of portfolio Past average change in return relative to changes in the market return d Required rate of return using CAPM First find risk free rate beta and expected market return Now use the capital asset pricing model to put these numbers together Chapter 10 1 Understand the risk profiles of different capital budgeting projects a 3 types of projects Replacement expansion new venture These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute 2 3 4 5 6 7 b Expansion is risky requires investing money in additional resources and equipment c Replacement is safest doing something firm has done before d New venture is most risky because it s something company has never done before What constitutes incremental cash flows a Incremental cash flows The additional operating cash flow that an organization receives from taking on a new project What are the advantages and disadvantages of using the payback method a Advantages of payback b Disadvantages of payback First Ignores time value of money thus future dollars are weighted equally with present dollars Second ignores cash flows after the payback period This can lead to a wrong answer even in simple cases What is NPV and how is it interpreted a NPV is the sum of the present values of its cash inflows and outflows at the cost of capital b A project s NPV is the net effect that the undertaking is expected to have on the value of the firm Therefore a capital spending program that maximizes the NPV of projects undertaken will contribute to maximizing shareholder wealth the ideal goal of management What is IRR and how is it interpreted a IRR is the return it generates on the investment of its cash flows b IRR is the interest rate that makes a project s NPV zero c If IRR exceeds cost of capital project is acceptable on stand alone basis IRR k accept Why is capital budgeting difficult to do What is the most difficult leading to inaccuracies part of capital budgeting a Capital budgeting is difficult because estimating project cash flows is often inaccurate Know how to calculate NPV 8 Know how to calculate using payback method a Payback Period Cost of Project Annual Cash Inflows 9 Know how to calculate IRR when projected cash flows are an annuity Chapter 13 1 Understand the concept of cost of capital its purpose and how is it used for capital budgeting and valuation pp 454 456 a Cost of capital average rate paid for the use of capital funds Can be thought of as its required return for all capital budgeting projects that have risk levels approx equal to its own size 2 Is debt generally cheaper or more expensive than equity Why a Because component securities have different risks they offer different returns and have different costs Equity is highest debt is lowest preferred is in between 3 Understand the concept and calculation of Weighted Average Cost of Capital WACC a WACC is a weighted average of component costs where the weights reflect the amount of each component used b For calculation please go to pg 561 in the textbook 4 What are the various components when calculated cost of capital a Components of Cost of Capital i Cost of Debt 1 Debt issued at par 2 Debt issued at premium or discount ii Cost of preference capital 5 Understand the difference between the book value and the market value of a firm s capital structure a Book value reflects the prices of the securities that raised its capital that were originally sold and are embodied in the capital section of its balance sheet b Market values reflect the current market price of the same securities 6 Know how to calculate the after tax cost of debt a To get the after tax rate multiply the before tax rate by one minus the marginal tax rate b before tax rate x 1 marginal tax 7 Know how to calculate cost of preferred stock a Cost of preferred stock investor s return adjusted for flotation costs b Please go to pg 567 for formula and calculation 8 Know how to calculate cost of newly issued common stock a Cost of equity comes from stock and retained earnings which both have different costs b 3 approaches CAPM constant growth Gordon model Risk Premiums i CAPM kx krf km krf bx page 569 1 Kx required rate of return on stock X 2 Krf risk free rate 3 Km market return 4 Bx stock X s beta coefficient ii Gordon page 570 1 P0 D0 1 g ke g page 570 a P0 Current Stock price b D0 most recent dividend paid c Ke expected return d G anticipated constant growth rate iii Risk Premium page 571 1 Ke kd rpe page 571 a Kd and Ke are market returns on debt and equity Rpe is the additional risk premium on equity Chapter 14 1 Understand the concept of financial