Finance Test #2 Flashcards
What is the equity market risk premium?
The excess return from the equity market above a risk-free rate
Historical estimates are used for forecasting needs.
How is risk measured in Portfolio Theory?
Risk is a function of the variance or standard deviation of an asset and its correlation with the volatility of other assets in the portfolio.
What is mean variance optimization?
A procedure using linear programming or software to determine the best weighting for different investment options in a portfolio.
What effect does diversification have on a portfolio?
Reduces non-systematic risk.
What does the Sharpe Ratio measure?
Return per unit of total risk
It is calculated as (Return on the Portfolio - Risk Free Rate) / Standard Deviation of the Portfolio.
What is the Capital Asset Pricing Model (CAPM)?
A model used to calculate the expected return of an asset based on its risk relative to the market.
What are the implications of adding a risk-free asset to a portfolio?
The efficient frontier shifts to become a line extending from the risk-free rate.
How do you determine the expected return of stock using CAPM?
Using the formula: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate).
What is the difference between common stock issued and outstanding, and treasury shares?
Issued shares are all shares that have been sold, while outstanding shares are those currently held by shareholders excluding treasury shares.
What is the difference between primary and secondary markets?
Primary markets are for new issues where funds go to the issuer; secondary markets involve trading where funds exchange hands between buyers and sellers.
What is the dividend yield?
The ratio of a company’s annual dividend compared to its share price.
What is the payout ratio?
The proportion of earnings paid out as dividends to shareholders.
What are the theories of investor preferences regarding dividends?
- Irrelevance theory
- Bird-in-hand theory
- Tax preference theory
What is Free Cash Flow to Equity (FCFE)?
Cash available to distribute to shareholders after all expenses, reinvestments, and debt repayments.
What are advantages of share repurchase?
- Not an obligation like dividends
- May prefer tax reasons for shareholders
- Tactical decision by management
What is the cost of capital?
The return a company needs to earn on its investment projects to maintain its market value.
What is operating leverage?
The extent to which a company can increase its operating income by increasing revenue.
What is financial leverage?
The use of borrowed funds to increase the potential return on investment.
How do you calculate the Weighted Average Cost of Capital (WACC)?
WACC = (E/V * Re) + (D/V * Rd * (1 - Tc))
Where E is equity, D is debt, V is total value, Re is cost of equity, Rd is cost of debt, and Tc is corporate tax rate.
What is Beta in finance?
A measure of a stock’s volatility in relation to the overall market.
What is the significance of the Security Market Line (SML)?
It helps determine if a stock is overvalued or undervalued based on its expected return compared to its risk.
Fill in the blank: The process of raising public equity capital is called _______.
Initial Public Offering (IPO)
