Finance Midterm 2 Flashcards
Volatility is measured by:
- Variance
- Standard Deviation
Volatility of returns is what is considered as
Risk
Diversification:
Strategy designed to reduce risk by spreading the portfolio across many investments. This is possible because assets possess two kinds of risk.
Unique risk:
Risk factors affecting only that firm. Also called specific, diversifiable or non-systematic risk
Market risk:
Economy-wide (macroeconomic) source of risk that affects the overall stock market. Also called systematic or non-diversifiable risk
Portfolio Risk:
Portfolio standard deviation depends on the individuals stocks’ standard deviation and also on their correlation to one another
You cannot eliminate all risk from a portfolio by adding
Securities
Typically, once you get beyond 15 stocks, adding more stocks does
Very little to reduce the risk of the portfolio
The risk that cannot be diversified away is called:
Market risk (or systematic or non-diversifiable risk)
For reasonably well diversified portfolio
Only market risk matter
Capital Asset Pricing Model (CAPM)
A Model to analyze the risk and required rates of return on assets when held in portfolios
7 assumptions of CAPM:
- Investors choose among portfolios on the basis of means and standard deviation
- Individuals can borrow and lend at the risk-free rate
- Investors have homogeneous expectations
- Assets are perfectly divisible and liquid
- Not transactions costs or taxes
- Investors are price takers
- Quantities of all assets are given and fixed
The Market Portfolio:
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
The market portfolio is used as a
Benchmark to measure the risk of individual stock
Beta
Sensitivity of a stock’s return on the market portfolio and a measure of market risk
Portfolio Beta
The weighted average of the betas of the individual assets; with the weight being equal to the proportion of wealth invested in each asset
Market Risk Premium
The difference between the expected return on the market portfolio and the interest rate on Treasury bills (risk free asset)
Since the return on the t-bill is fixed and unaffected by what happens in the market;
The beta of the risk-free asset is zero
By definition, the beta of the market portfolio is
1
Security Market Line
The relationship between the market risk of the security (beta) and its expected return
According to the CAPM, what lies on the SML?
Expected rates of return for all securities and all portfolios
Company Cost of Capital
Is the expected rate of return demanded by investors in a company, determined by the average risk of the company’s assets and operations
Project Cost of Capital
Is the minimum acceptable expected rate of return on a project given its risk
Weighted Average Cost of Capital
Is the expected rate of return on a portfolio of all the firm’s securities, adjusted for tax saving due to interest payments
The cost of capital must be based on
What investors are actually willing to pay for the company’s outstanding securities
The interest payments on the debt are
Deducted from income before tax is calculated
Issues with using WACC
- Changing the capital structure
- Changing the capital structure might affect beta
[Changing the capital structure] If leverage increases
The debt is riskier so debtholders are likely to demand a higher return
[Changing the capital structure] As shareholders are paid only after debtholders
Increasing debt may also increase the shareholders’ required rate of return
[Changing the capital structure] There are actually two costs of debt finance
- The explicit cost of debt
- The implicit cost of debt
Explicit Cost of Debt
The rate of interest that bondholders demand
With increased debt there is
More financial risk to shareholders as they are paid only after debt holders receive their promised interest and principal
Increasing leverage raises the debt-equity ratio and
Increases the financial risk to shareholders resulting in higher beta
A company’s WACC is the right
Discount rate for average risk project
The WACC is the return the company needs to
Earn on its investments, after tax, to satisfy all its security holders
If the firm increases its debt ratio
Both the debt and equity will become riskier
3 Pitfalls of the IRR Rule
- Lending or Borrowing?
- Mutually exclusive projects involving different outlays
- Multiple rates of return
Incremental Cash Flows Cash Flows
A project’s PV depends on the extra (or incremental) cash flow it produces
Incremental Cash Flow =
Cash flow with project - cash flow without project
Identifying Cash Flows, things to look out for
- Include all indirect effects
- Forget sunk costs
- Include opportunity costs
- Recognize the working capital investment
- Remember shutdown cash flows
- Beware of allocated overhead costs
- Separate investment and financing decisions
Half-year rule:
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
Project cash flows do not equal
Profit. Allow for changes in working capital and depreciation
CCA reduces
Taxable income and tax
Most asset classes use what to calculate CCA
Declining balance
Most assets generate CCA tax shields over
An infinite time frame
Calculate PV of operating cash flows separately from the
PV of the CCA tax sheilds
