HB 311 1st Edition Exam #3 Study GuideChapter 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 risk3. 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 riska. Portfolio theory – Attempts to either maximize expected returns or minimize risk for a givenlevel of expected return, by carefully choosing proportions of various assetsb. 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 betaa. 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 determined7. Know how to calculate:a. Expected return – Mean of each distributionb. 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 returnd. 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 101. Understand the risk profiles of different capital budgeting projects.a. 3 types of projects: Replacement, expansion, new ventureThese 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.b. Expansion is risky, requires investing money in additional resources and equipment.c. Replacement is safest, doing something firm has done befored. New venture is most risky, because it’s something company has never done before2. What constitutes incremental cash flows?a. Incremental cash flows – The additional operating cash flow that an organizationreceives from taking on a new project.3. 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. 4. 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. 5. 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) 6. 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 inaccurate7. Know how to calculate NPV8. Know how to calculate using payback methoda. Payback Period = Cost of Project / Annual Cash Inflows9. Know how to calculate IRR when projected cash flows are an annuity.Chapter 131. 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 textbook4. What are the various components when calculated cost of capital.a. Components of Cost of Capital – i. Cost of Debt 1. Debt issued at par2. Debt issued at premium or discountii. 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 securities6. 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 costsb. Please go to pg. 567 for formula and calculation 8. Know how to calculate cost of newly issued common stocka. Cost of equity – comes from stock and retained earnings, which both have different costsb. 3 approaches: CAPM, constant growth (Gordon) model, Risk Premiumsi. CAPM: kx = krf +(km – krf)bx (page 569) 1. Kx = required rate of return on stock X2. Krf = risk free rate3. Km = market return4. Bx = stock X’s beta coefficientii. Gordon –(page 570)1. P0 = (D0 (1+g)) / (ke – g) (page 570)a. P0 = Current Stock priceb. D0 =