Estimating The Cost Of Capital Chap 12

Question 1

Value weighted portfolio/ equal-ownership portfolio

Answer 1

A portfolio in which is security is held in proportion to its market capitalisation. It consist of the same fraction of outstanding shares of each security.

Question 2

Passive portfolio

Answer 2

A portfolio that is not rebalanced in response to price changes

Question 3

Market index

Answer 3

The market value of a broad-based portfolio of securities

Question 4

Price-weighted portfolio

Answer 4

A portfolio that holds an equal number of shares of each stock, independent of their size

Question 5

Index funds

Answer 5

Mutual funds that invest in stocks in proportion to their representation in a published index, such as S&P, 500 and Walshire, 500

Question 6

Market proxy

Answer 6

A portfolio whose return in believed to closely tracked the true market portfolio

Question 7

Linear regression

Answer 7

The statistical technique that identifies the best-fitting line through a set of points

Question 8

Error (or residual) term

Answer 8

Represents the deviation from the best-fitting line in a regression. It is zero on average and uncorrelated with any regressors.

Question 9

Alpha

Answer 9

The difference between a Stocks expected return and it’s required to return according to the security market line. It measures the historical performance of the security relative to the expected return predicted by SML.

Question 10

Debt cost of capital

Answer 10

The cost of capital, or expected return, that a firm must be on its debt

Question 11

Unlevered cost of capital

Answer 11

The expected return required by the firms investors to hold of the firms underlying assets. It is the weighted average of the firms equity and debt cost of capital.

Question 12

Asset or unlevered beta

Answer 12

Measures the risk of a firm, who is unlevered; beta of the firms assets; measures the market risk of the firms business activities, ignoring any additional risk due to leverage.

Question 13

Net debt

Answer 13

Total debt outstanding minus any cash balances

Question 14

Operating leverage

Answer 14

Relative proportion of fixed versus variable costs

Question 15

The unlevered cost of capital (pretax WACC)

Answer 15

It is the expected return investors will earn holding the firms assets. In the world with taxes, it can be used to evaluate an all equity financed project with the same risk as the firm

Question 16

WACC

Answer 16

It is the effective after tax cost of capital to the firm. Because interest expense is tax-deductible, the WACC is less than the expected return of the firms assets. In the word with taxes, the WACC can be used to evaluate a project with the same risk and the same financing as the firm itself.