S13: Risk, Return, The Security Market Line, & Cost Of Capital

Question 1

Dividend & Capital Gain Yields

Answer 1

An investor’s return on an investment is their total gain or loss from holding onto an investment is their total gain or loss from holding the financial assets. It is the sum of the security’s:
1. Income component
2. Capital gain(loss) component

Question 2

Income Component

Answer 2

The dividends and/or interest received over the holding period

Question 3

Total % Return

Answer 3

Total % Return = dividend yield + capital gain yield
Total % Return = (Dt+1/Pt)+((Pt+1-Pt)/Pt)

Question 4

Realized Return

Answer 4

Return that actually occurred

Question 5

Expected Return

Answer 5

What we believe a security will yield

Question 6

Portfolios

Answer 6

Collections of securities, characterized by risk

Question 7

Expected Return E(R)

Answer 7

𝐸(𝑟) = ∑ 𝑝(𝑠)𝑟(𝑠) = 𝑝(𝑠1)𝑟(𝑠1) + 𝑝(𝑠2)𝑟(𝑠2) ⋯ + 𝑝(𝑠𝑆)𝑟(𝑠𝑆)

Question 8

Variance & Standard Deviation of Returns

Answer 8

Gives idea of “spread” or “range” of possible returns - the wider the spread, the greater the risk

Question 9

Steps to Calculate VAR and SD

Answer 9

1. Calculate R(boom) & R(bust) -> (1/3*%chance boom/bust)
2. Calculate E(rp) -> includes both R(boom&bust) calculations
3. Identify P(boom) & P (bust)
4. Combine and calculate VARboom & VARbust using 𝑉𝑎𝑟(𝑟) = 𝜎2 = ∑ 𝑝(𝑠)[𝑟(𝑠) − 𝐸(𝑟)]2
5. Sum boom and bust var for VAR & square root for SD

Question 10

Interpreting SD & E(Rp) results

Answer 10

1. 99% within +- 3 SDs of E(Rp)
2. 96% within +- 2 SDs of E(Rp)
3. 68% within +- 1 SDs of E(Rp)

Question 11

Risk

Answer 11

Uncertainty, or dispersion, around our expectations. Can be positive or negative

Question 12

Systematic Risk

Answer 12

Affects many assets - surprises that affect market overall (not able to reduce to 0)

Question 13

Unsystematic Risk (aka firm risk)

Answer 13

Unique to individual firm (can be eliminated through diversification)

Question 14

Diversification

Answer 14

Process of developing a portfolio or collection of assets to reduce your risk - only eliminates unsystematic risk

Question 15

Beta

Answer 15

Measure of systematic risk

Question 16

CAPM

Answer 16

Tells expected rate of return (k)

Question 17

Security Market Line (SML)

Answer 17

A line connecting the E(R) of a security with the E(Rm). Shows linear relationship between security’s expected or required rate of return and its Beta

Question 18

Market Portfolio

Answer 18

Consists of all assets/available securities, Beta always = 1

Question 19

Cost of Capital

Answer 19

Returns for investors are costs for firm

Question 20

Cost of Equity

Answer 20

The return that E investors require on their investment in the firm (determined by CAPM) =
Shares Outstanding * Price per Share

Question 21

Cost of Debt

Answer 21

The return that bond investors - the lenders - require on the firm’s debt (determined by firm’s bonds’ YTMs), D=Par value * % of par that market is trading at

Question 22

Weighted Average Cost of Capital (WACC)

Answer 22

The weighted average of the cost of equity and after-tax cost of debt. It is the overall return the firm must earn on its existing assets to maintain the firm’s value, taking into account the firm’s capital structure

Question 23

Capital Structure

Answer 23

The % of the firm financed with debt vs % financed with equity

Question 24

Market Capitalization

Answer 24

E, the market value of stock

Question 25

What does the cost of capital depend on?

Answer 25

Use of funds, not the source

Question 26

WACC Uses

Answer 26

NPV= Use WACC for discount rate
IRR= Use WACC for “hurdle rate” for comparison