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zFundamentals of Corporate Finance > Chapter 12 > Flashcards

Chapter 12 Flashcards

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1
Q

What are the two components for a return on your investment?

A
  1. Income component: cash payment such as interest or dividend
  2. Capital component: capital gain/loss –> “price change”
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2
Q

How do we calculate total dollar return?

A

Total dollar return = Dividend income + Capital gain (or loss)

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3
Q

How do we calculate dividend yield?

A

Dividend yield = Dividend return/Initial investment

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4
Q

How do we calculate the capital gains yield?

A

Capital gains yield = [P(1) - P(0)]/P(0)

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5
Q

The return is __________ by the decision to sell or hold securities.

A

unaffected

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6
Q

What are large company stocks?

A

S&P 500 Index, which contains 500 of the largest companies in terms of total market value in the U.S.

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7
Q

What are small company stocks?

A

Smallest 20% of stocks listed on the New York Stock Exchange bsed on market value of outstanding stock.

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8
Q

What are long-term corporate bonds?

A

High quality corporate bonds with 20 years to maturity

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9
Q

What are long-term government bonds?

A

Portfolio of U.S. government bonds with 20 years to maturity

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10
Q

What are U.S. Treasury Bills?

A

Portfolio of T-bills with a 3 month maturity

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11
Q

From 1926-2013, small company stocks performed the __________. U.S. treasury bills performed the __________.

A

best

worst

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12
Q

The variability in returns is much __________ for small-company stocks than U.S. treasury bills.

A

larger

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13
Q

What is the arithmetic average return and how do we calculate it?

A

The return earned in an average year over a multiyear period.
(SUM of all the returns)/(# of returns) = Arithmetic Average

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14
Q

What is the geometric average return and how do we calculate it?

A

The average compound return earned per year over a multiyear period.
(MULTIPLY all returns)^[1/(# of returns)] - 1 = Geometric Average

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15
Q

What is a risk premium?

A

reward for bearing risk, the difference between a risky investment return and the risk-free rate.

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16
Q

What is excess return?

A

The difference between an average-risk return (aggregate common stocks) and the return on T-bills (risk-free).

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17
Q

For large company stocks, the average annual risk premium has been approximately ______% since 1926. For smaller (and presumably riskier) firms, the average annual risk premium has been ______% over the same period.

A
  1. 2

13. 0

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18
Q

__________ and __________ __________ are the most commonly used measures of volatility.

A

Variance

Standard deviation

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19
Q

What is variance?

A

the average squared deviation between actual returns and their mean

20
Q

What is standard deviation?

A

square root of variance

21
Q

The standard deviation for small-company stock is about ______ times larger than that of U.S. treasury bills.

A

10

22
Q

Historical returns on securities have probability distributions that are approximately __________.

A

normal

23
Q

The normal distribution is completely described by its __________ and __________.

A

mean

variance

24
Q

Since 1926, annual returns on large company stocks have averaged about ______% with a standard deviation of about ______%.

A
  1. 9

20. 4

25
Q

An observation on a normally distributed random variable has a ______% chance of being within plus or minus 1 standard deviation from the mean, a ______% chance of being within plus or minus 2 standard deviations from the mean, and a __________% chance of being within plus or minus 3 standard deviations from the mean.

A

68
95
99

26
Q

The greater the potential __________, the greater is the __________.

A

reward

risk

27
Q

Over the period 1926-2010, only the year ______ had a lower return than ______ (-44% vs. 37%).

A

1931

2008

28
Q

From November 2007 to March 2009, the S&P 500 __________ value; however, from March 2009 to February 2011, the S&P 500 __________ value.

A

lost 50% of its

doubled in

29
Q

In 2008, long-term U.S. treasuries were up almost ______%.

A

40

30
Q

A __________ portfolio would have suffered much smaller losses in 2008 than an __________ portfolio.

A

well-diversified

all-stock

31
Q

Based upon the historical risk premium for large company stocks, an investment of “average risk” should return about ______% above the T-bill rate.

A

8.2

32
Q

From 1900-2005, the U.S. had a stock market risk premium of ____% near average for highly developed nations with ____%.

A
  1. 4

7. 1

33
Q

The standard error from 1900-2005 estimate is about ____%.

A

2

34
Q

Geometric means will always be __________ than arithmetic means unless all returns are equal.

A

smaller

35
Q

The arithmetic average is probably best for __________ planning horizons and the geometric average is probably best for __________ planning horizons.

A

short

very long

36
Q

If your planning horizon is somewhere in the middle, say 25 to 40 years, then split the difference between the two, which can be done more specifically using __________ __________.

A

Blume’s formula

37
Q

What is Blume’s formula?

A

R(T) = [(T - 1)/(N - 1)] * Geometric Average + [(N - T)/(N - 1)] * Arithmetic Average

Where T is our planning horizon and N is the # of historical data period we have available.

38
Q

What is an efficient capital market?

A

Market in which current market prices fully reflect available information. In such a market, it is not possible to devise trading rules that consistently “beat the market” after taking risk into account.

39
Q

What is the Efficient Market Hypothesis (EMH)?

A

Modern U.S. stock markets are, in general, efficient. An important implication of the EMH is that the expected return on securities equals their risk-adjusted required return.

40
Q

What makes a market efficient?

A

competition among investors and traders

41
Q

Market efficiency (does/does not) imply that it doesn’t make a difference how you invest, since the risk/return trade-off still applies, but rather that you can’t expect to consistently earn excess returns using costless trading strategies.

A

does NOT

42
Q

__________ are evidence that the market is efficient since new information is constantly arriving; __________ are evidence of inefficiency.

A

Stock price fluctuations

prices that DON’T change

43
Q

What causes randomness in price changes?

A

the influence of previously unknown information

44
Q

What is strong form efficiency?

A

All information, both public and private, is already incorporated in the price. Empirical evidence indicates that this form of efficiency does NOT hold.

45
Q

What is semi-strong form efficiency?

A

All public information is already incorporated in the price. It says that you cannot consistently earn excess returns using available information to do fundamental analysis. Evidence is mixed, but suggests that it holds for widely held firms.

46
Q

What is weak form efficiency?

A

All market information, including prices and volume, is included in the price. It says that you cannot consistently earn excess returns by looking for patterns in past price and volume information, such as is done by technical analysts. Evidence suggests that markets are weak form efficient based on the trading rules that we have been able to test.

47
Q

If you buy an asset of any sort, your gain (or loss) from that investment is called the __________.

A

return on your investment

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