FIN3403 Test 3 important note Bold important term that isn t a vocab word Bold Underlined vocab word Chapter 13 13 1 Expected Returns and Variances Expected Return E R the return on a risky asset expected in the future Risk Premium Expected Return Risk Free Rate Possible Deviations the difference between the actual returns and the expected returns Variance is the sum of each deviation squared and then multiplied by its possibilities pg 415 3 2 Portfolios Portfolio group of assets such as stocks and bonds held by an investor Portfolio Weights percentage of a portfolio s total value that is invested in a particular asset amount in asset amount in whole portfolio Portfolio Expected Returns the sum of the expected returns of each asset multiplied by their portfolio weight pg 417 Portfolio Variance the sum of each market state s difference between its actual return in that state and the portfolio expected return squared and then multiplied by the state s probability pg 418 419 Portfolio Standard Deviation square root of Portfolio Variance 13 3 Announcements Surprises and Expected Returns Expected return is the return that shareholders in the market predict or expect it relies on info the shareholders have that bears on the stock Unexpected return is the return that comes from unexpected info revealed during a year i e news about the company government announcements changes in interest Total Return Expected Return Unexpected Return R E R U 13 4 Risk Systematic and Unsystematic Systematic Risk risk that influences a large number of assets market risk Unsystematic Risk risk that influences at most a small number of assets unique or asset specific risk R E R Systematic Unsystematic 13 5 Diversification and Portfolio Risk Principle of Diversification spreading an investment across a number of assets will eliminate some but not all of the risk Diversifiable Risk is the risk that can be eliminated by diversification not all risk is diversifiable Diversification reduces exposure to extreme outcomes both good and bad Unsystematic Risk is essentially eliminated by diversification so a portfolio with many assets has almost no unsystematic risk Total Risk Systematic Risk Unsystematic Risk 13 6 Systematic Risk and Beta Systematic Risk Principle expected return on a risky asset depends only on that asset s systematic risk systematic risk is the crucial determinant of an asset s E R Beta Coefficient amount of systematic risk present in a particular risky asset relative to that in an average risky asset an average asset has a beta of 1 0 relative to itself larger beta greater systematic risk Portfolio Beta is the sum of each asset s beta multiplied by that asset s weight 13 7 The Security Market Line Portfolio with one Risk Free RF Asset and one regular asset A E R of the portfolio weight of asset A E R of asset A weight of RF asset RF rate Beta of portfolio weight of asset A beta of A weight of RF asset beta of RF asset Beta of a RF asset is always 0 Reward to Risk Ratio E R of asset A RF rate beta of A risk premium per unit of systematic risk higher reward to risk ratio superior return for level of risk the reward to risk ratio must be the same for all the assets in the market SML Security Market Line between expected return and beta positively sloped straight line displaying the relationship SML Slope E R of the market RF rate Market Risk Premium Market Risk Premium the slope of the SML the difference between the E R on a market portfolio and the RF rate Capital Asset Pricing Model CAPM equation of the SML showing the relationship between expected return and beta CAPM RF rate E R of market RF rate beta of the asset 436 pg E R of any asset in the market there is a Table 13 9 on pg 437 that would be helpful to review 13 8 The SML and the Cost of Capital A Preview Cost of Capital minimum required return on a new investment Chapter 14 14 1 The Cost of Capital Some Preliminaries the cost of capital for a risk free investment is the risk free rate the cost of capital associated with an investment depends on the risk of that investment the cost of capital depends primarily on the use of the funds not the source Capital Structure is the particular mixture of debt and equity a firm chooses to employ 14 2 The Cost of Equity Cost of Equity RE return that equity investors require on their investment in the firm Dividend Growth Model Approach RE next period s projected dividend price growth rate remember next period s projected dividend is the dividend just paid time 1 plus the growth rate Problems only applicable for a company that pays dividends and which reasonably steady growth is likely to occur doesn t explicitly cover risk SML Approach RE RF rate estimated beta market risk premium RF rate estimated beta E R of market RF rate Problems relies on the accuracy of market risk premium and beta estimates 14 3 The Cost of Debt and Preferred Stock Cost of Debt RD return that lenders require on the firm s debt the interest rate a firm must pay on new borrowing coupon rate on the firm s outstanding debt is irrelevant here Cost of Preferred Stock Debt Dividend Price 14 4 The Weighted Average Cost of Capital E market value of the firm s equity D market value of a firm s debt V value V E D After Tax Interest Rate Interest Rate 1 Tax Rate Weighted Average Cost of Capital WACC weighted average of the cost of equity and the after tax cost of debt WACC E V cost of equity D V cost of debt 1 tax rate If company uses preferred stock WACC E V cost of equity D V cost of debt 1 tax rate P V cost of preferred stock Table 14 1 on pg 465 would be helpful to look over 14 5 Divisional and Project Costs of Capital Pure Play is a company that focuses on a single line of business Pure Play Approach use of a WACC that is unique to a particular project based on companies in similar lines of business Chapter 16 16 1 The Capital Structure Question the value of a firm is maximized when the WACC is minimized WACC is the appropriate discount rate for the firm s overall cash flows optimal capital structure lowest possible WACC 16 2 The Effect of Financial Leverage Financial Leverage is the extent to which a firm relies on debt EPS Earnings Per Share ROE Return On Equity the effect of financial leverage depends on the company s EBIT Earnings Before Interest and Taxes whet EBIT is relatively high leverage is beneficial Homemade Leverage use of personal borrowing to change the overall amount of financial leverage to which the individual is
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