Refresher Finance course

Question 1

What is the difference between systematic and unsystematic (idiosyncratic) risk?

Answer 1

Systematic risk affects nearly all, or at least many, stocks. They are usually general economic conditions

Unsystematic/idiosyncratic risk affects single securities or a small group of assets

Question 2

What are the three determinants of beta?

Answer 2

1. Cyclicality of revenues
2. Operating leverage
3. Financial leverage

Question 3

What is operating leverage?

Answer 3

Operating leverage measures how revenue growth translates into operating income growth. When profits are more responsive to volume changes, operating leverage is higher.

Operating leverage magnifies cyclicality. Higher fixed costs means higher operating leverage

Question 4

What is financial leverage?

Answer 4

Extent to which a firm relies on debt

Question 5

What is adverse selection?

Answer 5

Counterparty will lose money if trader has information the counterparty does not possess.

Informed traders raise the required retorn, increasing WACC.

Question 6

Describe two strategies to lower the WACC

Answer 6

1. Bring in more uninformed traders (i.e. stock splits). Reduces adverse selection, which results in a lower bid-ask spread
2. Disclose more information, which narrows the information gap