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Finance Midterm 2 Flashcards

1
Q

Volatility is measured by:

A
  • Variance
  • Standard Deviation
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2
Q

Volatility of returns is what is considered as

A

Risk

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3
Q

Diversification:

A

Strategy designed to reduce risk by spreading the portfolio across many investments. This is possible because assets possess two kinds of risk.

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4
Q

Unique risk:

A

Risk factors affecting only that firm. Also called specific, diversifiable or non-systematic risk

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5
Q

Market risk:

A

Economy-wide (macroeconomic) source of risk that affects the overall stock market. Also called systematic or non-diversifiable risk

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6
Q

Portfolio Risk:

A

Portfolio standard deviation depends on the individuals stocks’ standard deviation and also on their correlation to one another

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7
Q

You cannot eliminate all risk from a portfolio by adding

A

Securities

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8
Q

Typically, once you get beyond 15 stocks, adding more stocks does

A

Very little to reduce the risk of the portfolio

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9
Q

The risk that cannot be diversified away is called:

A

Market risk (or systematic or non-diversifiable risk)

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10
Q

For reasonably well diversified portfolio

A

Only market risk matter

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11
Q

Capital Asset Pricing Model (CAPM)

A

A Model to analyze the risk and required rates of return on assets when held in portfolios

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12
Q

7 assumptions of CAPM:

A
  1. Investors choose among portfolios on the basis of means and standard deviation
  2. Individuals can borrow and lend at the risk-free rate
  3. Investors have homogeneous expectations
  4. Assets are perfectly divisible and liquid
  5. Not transactions costs or taxes
  6. Investors are price takers
  7. Quantities of all assets are given and fixed
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13
Q

The Market Portfolio:

A

Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P/TSX or S&P Composite Index, is used to represent the market

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14
Q

The market portfolio is used as a

A

Benchmark to measure the risk of individual stock

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15
Q

Beta

A

Sensitivity of a stock’s return on the market portfolio and a measure of market risk

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16
Q

Portfolio Beta

A

The weighted average of the betas of the individual assets; with the weight being equal to the proportion of wealth invested in each asset

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17
Q

Market Risk Premium

A

The difference between the expected return on the market portfolio and the interest rate on Treasury bills (risk free asset)

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18
Q

Since the return on the t-bill is fixed and unaffected by what happens in the market;

A

The beta of the risk-free asset is zero

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19
Q

By definition, the beta of the market portfolio is

A

1

20
Q

Security Market Line

A

The relationship between the market risk of the security (beta) and its expected return

21
Q

According to the CAPM, what lies on the SML?

A

Expected rates of return for all securities and all portfolios

22
Q

Company Cost of Capital

A

Is the expected rate of return demanded by investors in a company, determined by the average risk of the company’s assets and operations

23
Q

Project Cost of Capital

A

Is the minimum acceptable expected rate of return on a project given its risk

24
Q

Weighted Average Cost of Capital

A

Is the expected rate of return on a portfolio of all the firm’s securities, adjusted for tax saving due to interest payments

25
Q

The cost of capital must be based on

A

What investors are actually willing to pay for the company’s outstanding securities

26
Q

The interest payments on the debt are

A

Deducted from income before tax is calculated

27
Q

Issues with using WACC

A
  1. Changing the capital structure
  2. Changing the capital structure might affect beta
28
Q

[Changing the capital structure] If leverage increases

A

The debt is riskier so debtholders are likely to demand a higher return

29
Q

[Changing the capital structure] As shareholders are paid only after debtholders

A

Increasing debt may also increase the shareholders’ required rate of return

30
Q

[Changing the capital structure] There are actually two costs of debt finance

A
  • The explicit cost of debt
  • The implicit cost of debt
31
Q

Explicit Cost of Debt

A

The rate of interest that bondholders demand

32
Q

With increased debt there is

A

More financial risk to shareholders as they are paid only after debt holders receive their promised interest and principal

33
Q

Increasing leverage raises the debt-equity ratio and

A

Increases the financial risk to shareholders resulting in higher beta

34
Q

A company’s WACC is the right

A

Discount rate for average risk project

35
Q

The WACC is the return the company needs to

A

Earn on its investments, after tax, to satisfy all its security holders

36
Q

If the firm increases its debt ratio

A

Both the debt and equity will become riskier

37
Q

3 Pitfalls of the IRR Rule

A
  1. Lending or Borrowing?
  2. Mutually exclusive projects involving different outlays
  3. Multiple rates of return
38
Q

Incremental Cash Flows Cash Flows

A

A project’s PV depends on the extra (or incremental) cash flow it produces

39
Q

Incremental Cash Flow =

A

Cash flow with project - cash flow without project

40
Q

Identifying Cash Flows, things to look out for

A
  1. Include all indirect effects
  2. Forget sunk costs
  3. Include opportunity costs
  4. Recognize the working capital investment
  5. Remember shutdown cash flows
  6. Beware of allocated overhead costs
  7. Separate investment and financing decisions
41
Q

Half-year rule:

A

Only one-half of the purchase cost of the asset is added to the asset class and used to compute CCA in the year of purchase

42
Q

Project cash flows do not equal

A

Profit. Allow for changes in working capital and depreciation

43
Q

CCA reduces

A

Taxable income and tax

44
Q

Most asset classes use what to calculate CCA

A

Declining balance

45
Q

Most assets generate CCA tax shields over

A

An infinite time frame

46
Q

Calculate PV of operating cash flows separately from the

A

PV of the CCA tax sheilds

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