Exam 3 Study Guide not necessarily exhaustive Chapter 12 annual returns time periods 1 Why do we commonly use percentage rather than dollar returns Why do we calculate Calculate annual returns so we can compare different securities over different Percentage return end price beginning price dividends or interest beginning price Use percentage returns because that way your return doesn t depend on how much you invest 2 Explain the relationship between risk and reward Risk is uncertainty The greater the risk systematic the greater the reward possible return 3 What information do financial markets provide us about returns Historically returns are approximately normal 4 Rank large stocks small stocks government bonds and treasury bills according to historical risk and return You do not need to know historical numbers but should know relative levels of return and risk Treasury bills Government Bonds Corporate Bonds Large Company Stocks Small Company Stocks Smallest to Largest returns 5 What type of market security do we normally use to represent the risk free rate A three month Treasury bill is used to assume the risk free rate of return because they have a very small amount of risk 6 What is a risk premium Excess return required of a risky investment over the required return on a risk free investment It s the compensation for bearing extra risk 7 What statistic is commonly used as a measure of the total risk of an asset Can be either variance or standard deviation We usually use standard deviation though Standard deviation is the square root of variance 8 Be able to calculate the variance and standard deviation of historic returns 9 What is the difference between an arithmetic and geometric average When should each be used Be able to calculate each if given a set of data Arithmetic Normal way of taking an average The average return earned in a year over multiple years Tells you what you earned in a typical year This is the average we ll use Geometric The average compound return earned per year over multiple years What you actually earned per year compounded annually Useful for calculating how many dollars you could earn It will be lower than arithmetic unless all returns are equal 10 What does the Efficient Capital Markets hypothesis say about markets Define strong form semistrong form and weak form efficient markets Assumes a market where security prices fully reflect the available information In other words there is no reason to believe a price is too high or too low The theory says that well organized markets such as the NYSE are efficient and that their inefficiencies are infrequent and minor Because everything is reflected in the price all projects NPV s are 0 Strong All information public and private is reflected Not even insider information could be used to receive an abnormal return Semi strong All public information is reflected Only non public information not widely known can be used to get an abnormal return Weak All market information is reflected This means all the stocks past prices are reflected in it s current price and that technical analysis can t be used to make abnormal returns Chapter 13 1 What is an expected return An unexpected return Expected return best guess of what will happen in the future based on possibilities Return you expect from investing in an asset Unexpected return Can be positive or negative 2 types Systematic risk Risk that affects a large number of assets Economy as a whole economy Unsystematic risk Effects small number of assets Just on area of Unsystematic risk can be minimized by diversification having multiple investments in your portfolio Total return expected return unexpected return Beta is used as a measure of systematic risk Compares amount of systematic to average amount of risk 2 What risk can an investor expect to be compensated for Systematic risk 3 What does the security market line represent The relationship between expected return and beta systematic risk It tells us the reward for bearing risk in a market 4 Explain the Capital Asset Pricing Model Aka CAPM Develops a way of measuring the reward to risk ratio slope of sml using the market portfolio as a key This is the equation of the SML 5 What discount rate should be used to analyze a project under consideration for investment The expected return offed in financial markets on investments with the same systematic risk beta 6 Be able to calculate expected return variance and standard deviation for an asset and portfolio portfolio weights for assets in a portfolio the beta coefficient for a portfolio given the component security information and required return for an asset given inputs to CAPM Chapter 14 1 Define Required Return The return that must be exceeded for the NPV of a project to be positive Appropriate discount rate and cost of capital are synonyms for the required return and are used interchangeably 2 Define Cost of Capital Cost of funds used to finance a company THE COST OF CAPITAL DEPENDS ON THE USE OF THE FUNDS NOT THE SOURCE Reflects the required return on assets as a whole will reflect cost of debt and cost of equity It is calculated using the WACC Weighted average cost of capital 3 Define Cost of Equity The return equity investors require on their investment in the firm There is no way of observing this it must be estimated Be able to calculate using the Dividend Growth Model Approach What are advantages and disadvantages of this approach Re D1 P0 g Be able to calculate using the SML Approach What are the advantages and disadvantages of this approach CAPM 4 Define Cost of Debt How is it calculated The yield to maturity on a bond Debt is also known as financial leverage leverage can be a good thing for shareholders Using debt gives the firm a tax shelter Rd x Wd x 1 Tc After tax cost of debt Rd is the before tax cost of debt and it the YTM on long term bonds 5 Define Cost of Preferred Stock How is it calculated Since preferred dividends are the same from year to year we treat them as a perpetuity Rp D P where D is the constant dividend and P is the price 6 What are Capital Structure Weights How are they calculated 7 How do taxes affect the WACC Taxes effect the after tax cost of debt Rd An increase in the capital gains tax rate will increase cost of debt and therefore increases the WACC as well 8 What is the Weighted Average Cost of Capital How is it calculated What is it used for The WACC in essence is a hurdle rate for a project with average riskiness The cost
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