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HB 311: FINAL EXAM
Relationship between risk and return |
-depends on tolerance for risk
|
Required returns |
The return on an investment required by an investor given market interest rates and the investment's risk
|
Calculate required returns |
risk-free rate of return + (market risk+company unique risk)
|
Rf |
Risk Free Rate of Return
|
Portfolio theory |
-Investing in more than one security to reduce risk.
-If two stocks are perfectly positively correlated, diversification has no effect on risk.
-If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified.
|
Systematic risk |
(Market risk)
-Nondiversifiable
-Cannot be diversified away
|
Unsystematic risk |
(Company-unique risk)
-Diversifiable
-Can be reduced through diversification
|
Why do we have Beta? |
We need to be able to measure market risk
-a measure of the "sensitivity" of an individual stock's returns to changes in the market.
|
The market's beta is _____. |
Beta = 1 (average market risk)
Beta > 1 (more volatile)
Beta < 1 (less volatile)
|
Capital asset prcing model (CAPM) |
This linear relationship between risk and required return
|
Do some firms have more market risk than others? |
Yes
|
Interest rate changes affect all firms, but which would be more affected:
a) Retail food chain
b) Commercial bank |
B |
To measure risk by using _____ for overall risk, and _____ for market risk. |
-standard deviation
-beta
|
We know how to reduce overall risk to only market risk through _______ |
diversification
|
Calculate expected return |
E(k) = (k1)(Pk1) + (k2)(Pk2) + (k3)(Pk3)
|
Calculate standard deviation as a meaure of risk |
((k1-Ek)) 2xPk1
+ ((k2-ek)) 2*Pk2
+ ((k3-Ek)) 2*Pk3
= ###
THEN TAKE SD
|
Simple return calculations |
(P2-P1)/P1 = %
|
Calculate beta of portfolio |
(# stock/total stock)*#betas
+
(# stock/total stock)*#betas
|
Required rate of return using CAPM |
ke=Rf+(km-rf)Beta
|
What is capital budgeting |
Expenditure on fixed assets that are large in nature and yield returns beyond one year
|
Risk profiles of different capital budgeting projects |
-Stand-Alone and Mutually Exclusive Projects
-Project Cash Flows
-The Cost of Capital
|
Advantages of using the payback method |
-It's quick and easy to apply
-Serves as a rough screening device
|
Disadvantages of using the payback method |
-Ignores the time value of money
-Ignores the cash flows after the payback period
|
Concept of cost of capital |
A firm's cost of capital is the average rate it pays its investors for the use of their money
|
Purpose of cost of capital |
-In general a firm can raise money from two sources: debt and equity
-If a potential project is expected to generate a return greater than the cost of the money to finance it, it is a good investment
-If cost to finance new project is 10% and expected return is 18% it creates value for the hotel.
|
Financial risk |
Due to debt financing
|
Business risk |
Variability of cash flows
|
Different methods of accelerating cash receipts: |
Lockbox, concentration banking, preauthorized checks, wire transfers.
|