Lecture Eight Flashcards
how to calculate the cost of equity
using the divident discount model DDM
Po= dividend1 / r - g
P0 = Current stock price
Divended1 = Expected dividend one year from now
r = Cost of equity (required rate of return)
g = Constant growth rate of dividends
Reraange to get r
r=Dividend1/Po + g
cost of equity formula
r=Dividend1/Po + g
what is the cost of equity Ke
the return that equity investors require on their investment in the company
- the required return by shareholders.
what does CAPM stand for
Capital asset pricing model
what does CAPM assume
a diversified portoflio
what is diversification
reduces specific risk (also known as unsystematic risk), which is unique to a particular company or industry.
whats is symstematic risk
Market risk
can diversification get rid of all risk
no, Market risk (systematic risk), however, cannot be eliminated through diversification
because it is linked to macroeconomic factors that affect the entire market (e.g., economic downturns, interest rate changes).
diverisifed portfolio in graphical explation
shows that as the number of stocks increases, specific risk decreases significantly.
However, market risk remains constant even after diversification.
what is the CAPM formula calculates
CAPM formula calculates the expected return on a security (Cost of Equity, Ke)
what is the CAPM formula
r = rf + B(rm-rf)
r= expected return on a secuirty
rf = risk free rate (e.g. returns on treasury bills)
B = beta factor
rm = market return (return of a index like ftse 100)
rm=rf = market risk premium, representing the additional return over the risk-free rate
what is beta measuring
measuring a stock’s sensitivity (volatility) to market movements
what if beta = 1
stock has average risk similar to the market.
what if beta > 1
The stock is more volatile than the market (aggressive).
what if beta is 0<B<1 (bigger then 0, smaller then 1)
The stock is less volatile than the market (defensive).
what if beta < 0
The stock has a negative correlation with the market (counter-cyclical).
what is rf
risk free rate
what is risk free rate
return on an investment with zero risk, typically represented by government securities like Treasury bills.
what is market return
average return of the entire market, often estimated using a market index (like the S&P 500).
what is the market risk premium
Represents the additional return expected from holding a risky market portfolio instead of risk-free assets.
what does the CAPM do for copoerations
estimate the cost of equity for projects, especially when the project risk differs from typical business operations.
what if theres high risk projects
will have a higher required return (higher discount rate).
The CAPM model helps in determining a risk-adjusted discount rate.
beta factors for portfolio
the weighted-average of the β factors of the individual securities
when would u use the CAPM model
when a project is above/below average risk i.e. the project is exposed to a different level
of risk compared to normal business operations.
Ie use a “risk adjusted discount rate
