Capital Markets And Pricing Of Risk

Question 1

Assumptions of CAPM

Answer 1

• investors can trade securities with no additional fees and can lend and borrow at a risk free rate
• Have homogenous expectations regarding volatility, correlation and expected return of securities (have the same estimates)
  -investors on,y hold portfolios that yield maximum expected return for a given level of volatility

Question 2

What’s the cost of capital

Answer 2

The return investors expect from an investment in a company and reflects risk of project and financing methods

Question 3

What is capital structure

Answer 3

Firms mix of long term debt and equity

Question 4

What does the project cost of capital depend on

Answer 4

Risk of project and how it is financed

Question 5

Difference between index funds and exchange traded funds

Answer 5

Index funds ; mutual funds that invest in S and P 500, the Wiltshire 5000 or some other index
Exchange traded funds; funds that are traded directly on exchange but represent ownership in a portfolio

Question 6

How does Rwacc compare with Ru
WACC= weighted average cost
Ru= equation involving debt and equity (expected return if there is NO debt)

Answer 6

Tax:
Companies benefit from a tax shield on debt.
Interest payments on debt are tax deductible. Tax is deducted from the interest payments and not from the company’s income. Therefore they save money. This is known as tax shield.
This means debt lowers the cost of capital as money is saved.
WACC takes tax inti consideration : calculation value would be lower than the one calculated from Ru :
WACC more realistic
Ru should be used when evaluating an all equity project
WACC should be used when evaluating project that considers all perspectives.

Question 7

When using WACC what value of securities should u use

Answer 7

MARKET VALUE Not book value.

Question 8

Define market value of bonds and equity

Answer 8

Market value of bonds: PV of all coupons and par value discounted at the current interest rate
Market value of equity: market price per share multiplied by the number of outstanding shares

Question 9

What is the pure play technique?

Answer 9

Method to estimate the expected return if a project by matching the risks of the project to a publicly traded company .
Once pure plays have been identified, market data is used to calculate required return

Question 10

What is net debt

Answer 10

Gives a more accurate picture of company’s real debt by considering how much cash they have.
Cash is considered a low risk asset due to its value not changing much: lowers overall risk of the company assets
Net debt = company’s debt minus cash and short term investment

Question 11

What is asset beta

Answer 11

Measures risk of assets without considering the debt .
High beta : more risky

Question 12

What determines asset betas

Answer 12

Cyclicality: how much company’s profits go up and down with the economy
If economy is bad and company’s profits go down and economy is good and profits go up = high cyclicality
High beta = more risky ( u can see that company performance depends on economy )

Operating leverage:
Refers to variable and fixed costs.
A company with high fixed costs = high operating leverage : high beta and therefore higher risk
Say sales go up, profits increase a lot as fixed costs don’t change
Sales go down, profits decrease however fixed costs still have to be paid
Low operating leverage = profits less sensitive to changes in sales

Question 13

Advantages of CAPM

Answer 13

although there are many assumptions when using this model
- errors in cost of capital estimates not likely to make large difference in NPV estimates
- practical. Easy to implement
-requires managers to think about risk in the right way

Question 14

S and P is a wide ranging US market index, so why does it have a low risk

Answer 14

Due to diversification.
S and P 500 represents a wide range of companies from different industries ( diversification )
This means that the risk of individual companies are spread out, when some companies perform poorly others do well and it balances.
Why?
Stocks don’t move same way due to being affected by different factors.
Industry specific issues
Company specific issues

Question 15

Difference between unsystematic and systematic risk

Answer 15

Unsystematic risk - risk that is specific to a company or industry e.g. poor management and it can be reduced by holding a diversified portfolio of different stocks
Systematic risk - risk that affects entire market/ economy and can’t be avoided as it impacts all companies

Question 16

What is risk premium of a security and what does it depend on

Answer 16

Risk premium : how much extra return investors expect for taking on risk.
Depends on its systematic risk