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Finance & investment > Second semester > Flashcards

Second semester Flashcards

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1
Q

Equity cost of capital

A

The expected return of other investments available in the market with equivalent risk to the firms shares

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2
Q

Condition under which an investor is willing to buy stock (Formula div discount model)

A

P0 = Div1 + P1/rE

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3
Q

Total return rE (dividend discount model)

A

Div1+p1/p0 -1 = Div1/P0 + P1-P0/P0 (Dividend gain + capital gain)

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4
Q

Dividend yield (%)

A

The expected annual dividend of the stock divided by its current price (Dividend/price)

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5
Q

Capital gain

A

Difference between expected sale price and purchase price for the stock (p1-p0)

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6
Q

P0 for multiyear investor (formula) dividend discount model

A

P0= (Div1/1+rE) +(Div2/(1+rE)^2 +… Divn/(1+rE)^n + Pn/(1+re)^n

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7
Q

Constant dividend growth model P0 (formula)

A

P0=Div1/rE-g

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8
Q

Dividend payout rate (dividend per share)

A

Div/Earnings x shares outstanding

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9
Q

In what three ways can firms increase dividends?

A

1) increase its earnings (net income)
2) It can increase its dividend payout rate
3) It can decrease its shares outstanding

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10
Q

New investment (formula) profit

A

Earnings x Retention rate

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11
Q

Retention rate

A

The fraction of current earnings that the firm retains

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12
Q

Earnings growth rate (formula)

A

Change in earnings /Earnings = Retention rate x Return on new investment

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13
Q

Dividend discount model with constant long term growth

A

P0 = Div1/1+rE + Div2/(1+re)^2

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14
Q

Share purchase

A

The firm uses excess cash to buy back its own stock

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15
Q

Discount free cash flow model

A

Determines the total value of the firm to all investors

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16
Q

Enterprise value Discount free cash flow model formula

A

Market value of equity +debt - cash

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17
Q

Discount free cash flow model formula

A

V0 = PV(Future free cash flow of firm)

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18
Q

Weighted average cost of capital

A

The average cost of capital the firm must pay to all of its invetors both debt and equity holders (The effective after tax cost of capital of the firm)

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19
Q

Valuation multiple

A

The ratio of the value to some measure of the firms scale

Example:

1) The price earning ratio multiple
2) Enterprise Value Multiples

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20
Q

-

A

-

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21
Q

Efficient market hypothesis

A

Competition among investors works to eliminate all positive NPV trading opportunities

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22
Q

Key implications for corporate managers

A

1) Focus on NPV and free cash flow
2) Avoid accounting illusions
3) use financial transactions to support investment

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23
Q

Probability distribution

A

Assigns a probability Pr that each possible return R will occur

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24
Q

Expected (mean) return formula

A

E(R)=SumR PrxR

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25
Q

Calculating realized annual returns formula 1+Rannual=

A

1+ Rannual = (1+ RQ1)(1+RQ2)(1+RQ3)(1+RQ4) = quarterly dividend rate

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26
Q

Average annual return

A

Is simply the average of the realized returns ofeach year

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27
Q

Average annual return of a security (formula)

A

1/T x (R1+R2+RT)

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28
Q

Standard error

A

Is the standard deviation of the estimated value of the mean of the actual distribution around its true value; That is the standard deviation of the average return

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29
Q

Standard error of the estimate of the expected return (formula)

A

SD(average of independend identical risk) = SD(individual risk)/sqroot Numer of observations

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30
Q

Common risk

A

Risk is perfectly correlated ; E.g Earthquake hits all houses

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31
Q

Independent risk

A

Risks without correlation Example: Thief breaks into one specific house

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32
Q

Firm-specific news

A

Is good or bad news about the company itself. For example, a firm might announce that it has been successful in gaining the market share within its industry

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33
Q

Market wide news

A

Is news about the economy as a whole and therefore affects all stock

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34
Q

Identifying systematic risk

A

Finding a portfolio that ocntains only systematic risk. Changes in this portfolio will correspond to systematic shocks to the economy (Efficient portfolio)

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35
Q

Efficient portfolio

A

Cannot be diversified further, bo way to reduce the risk without reducing the return

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36
Q

Beta

A

measures the sensitivity of a security to market wide risk factors

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37
Q

Market risk premium

A

E(r(mrk))-risk free interest rate

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38
Q

Estimating the cost of capital of an investment from its beta (cost of capital)

A

r1=risk free interest rate + beta1 x Market risk premium =rf+betax(E(Rmkt)-rf)

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39
Q

Xi (formula) (portfolio weights)

A

Value of investment i /Total value of portfolio

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40
Q

Expected return of a portfolio

A

the weighted average of the expected returns of the invstements within it using the portfolio weights

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41
Q

Efficient portfolio

A

offer investors the highest possible expected return for a given level of risk

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42
Q

Efficient frontier

A

highest possible expected return for a given level of volatility

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43
Q

sharpe ratio

A

Steepest possible tangent line on portfolio for return(y) risk(x) (risk-reward ratio)

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44
Q

Three main assumptions of the capital asset pricing model

A

Investors trade securities at competitive market prices (without incurring traxes or transaction costs) and can borrow and lend at the risk free rate

Investors choose efficient portfolios

Investors have homogeneous expectations regarding the volatilities, correlations and expected returns of securities

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45
Q

Equity cost of capital formula

A

E(Ri) = Rf + betai x(E(Rm) - RF)

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46
Q

market capitalization

A

The total market value of a firms outstanding shares (value of all shares you can buy combined)

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47
Q

Value-Weighted Portfolio

A

A portfolio in which each security is held in proportion to its market capitalization

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48
Q

Passive portfolio

A

A portfolio that is not rebalanced in resoponse to price changes

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49
Q

Active portfolio

A

The portfolio is frequent balanced with

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50
Q

Index funds

A

Mutual funds that invest in the S&P 500 etc

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51
Q

Exchange traded funds

A

Trade directly on an exchange but represent ownership in a portfolio in stocks

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52
Q

How to invest in an index in practice

A

You invest a mutual fund company. You will be a shareholder of the mutual company. That mutual company can invest in efts too

53
Q

How to estimate the historical risk premium

A

Estimate the risk premium (E(Rmrk) - rf) using the historical average exess return of the market over the risk free interest rate

54
Q

Debt betas

A

Debt betas are difficult to estimate because corporate bonds are traded infrequently. One appx is to use estimates of betas of bond indices by rating category

55
Q

Dividend discount model

A

Focuses on total discounted value of future dividends of firms. Has several limitations

56
Q

Total payout model

A

Ignores the firms choice between dividend and share repurchases, Values all of the firms equity, rather than a single share

57
Q

PV0 total payout model (formula)

A

= PV(future total dividends and repurchases)/Shares outstanding

58
Q

PV0 share price (discount free cash flow formula)

A

Pv0 = P0 = PV(Future cash flows)+ cash – debt / shares outstanding

59
Q

Change in earnings

A

New investment x Return on new investment

60
Q

Dividend formula

A

Earnings per share x payout ratio

61
Q

Limitations of the dividend discount model

A

Forecasting a firms dividend growth rate and future dividends is not easy

Little change in growth rate estimation may lead to big changes

62
Q

Discounted free cash flows model

A

Determines the value of the firm to all investors, including both equity and debt holders

63
Q

Free cash flow

A

Unlevered net income + Depreciation
−CapitalExpenditures − IncreasesinNetWorkingCapital

the cash flow available for the company to repay creditors or pay dividends and interest to investors

64
Q

V0 Formla (PV)

A

FCF/1+Weighted average cost of capital + FCF2/(1+WAAC)^2…+ Vn(Terminal value)/(1+waac)^n

65
Q

Ebit

A

Earnings before interest and taxes

66
Q

Forward price earnings ratio Formula

A

Dividend payout rate/rE-g or P0(share price)/EPS

The ratio is used for valuing companies and to find out whether they are overvalued or undervalued

67
Q

Multiples formula

A

Vo/EBITDA = (FCF/EBITDA)/re-gfcf

68
Q

Expected return on investment

A

Sum of all Probabilities x Returns

69
Q

Variance/volatity of investment

A

Sum of all probabilities x (Return - mean return)^2

70
Q

Realized return

A

Dividend yield + capital gain rate

71
Q

Sensitivity of systematic risk beta

A

measures sensitivity of individual stocks against systematic shocks (market)

The expected percent change in the excess return of a security for a 1% change in the excess return of the market portfolio.

72
Q

Covariance definition

A

The expected product of the deviations of two returns from their means

73
Q

Covariance formula (2 stocks)

A

Cov(Ri,Rj) = E[(Ri − E[Ri])(Rj − E[Rj])] /N-1

74
Q

Correlation definition

A

A measure of the common risk shared by stocks that does not depend on their volatility (that means that the risk of two stocks combined is less than the individual risk of both stocks)

75
Q

Correlation formula

A

Corr(Ri,Rj) = Cov(Ri,Rj) / SD(Ri) x SD(Rj)

76
Q

Variance portfolio (formula)

A

x1^2Var(R1) + x2^2Var(R2) + 2x1x2Cov(R1,R2)

Weighted average covariance of each stock in the portfolio

77
Q

variance of equally weighted portfolio formula

A

v^2/N +(1-1/N) x cov (v = variance)

78
Q

Expected return formula (portfolio + risk free investments)

A

(1-x) *rf + xE(Rp)

79
Q

Standard Deviation (portfolio + risk free investments)

A

xSD(Rp)

80
Q

Sharpe ratio formula

A

tan(alpha) = E(r)-rf/omega (Omega = SD)

81
Q

incremental change in sharpe ratio formula

A

𝐀𝐝𝐝𝐢𝐭𝐢𝐨𝐧𝐚𝐥𝐑𝐞𝐭𝐮𝐫𝐧𝐅𝐫𝐨𝐦𝐈𝐧𝐯𝐞𝐬𝐭𝐢𝐧𝐠𝐆𝐌 /𝐈𝐧𝐜𝐫𝐞𝐦𝐞𝐧𝐭𝐚𝐥𝐕𝐨𝐥𝐚𝐭𝐢𝐥𝐢𝐭𝐲 𝐟𝐫𝐨𝐦𝐢𝐧𝐯𝐞𝐬𝐭𝐢𝐧𝐠𝐆𝐌

E(RGM)-rf/SD(RGM) x corr(RGM, RP)

82
Q

beta formula

A

Cov(Ri,Rp)/Var(Rp) or change in market/change in stock)

OR Corr x SD1/SD2

83
Q

alpha definition

A

represents a risk-adjusted performance measure for the historical returns.

(If alpha is positive the stock has performed better than predicted by the CAPM)
(f αlpha is negative, the stock’s historical return is below the SML.)

84
Q

alpha formula

A

α=𝐸 𝑟 −{𝑟𝑓+β[𝐸 𝑟𝑀 −𝑟𝑓]}

85
Q

Debt cost of capital: default probability formula

A

rd = (1 − p)y + p(y − L) = y − pL

y= yield to maturity
rd= default probability
L= expected loss rate
86
Q

Debt cost of capital CAPM formula

A

d = risk free+(Debt Beta) X (Market Risk Premium)

87
Q

Projects cost of capital ru

A

ru= E/E+D *rE + D/E+D *rD

88
Q

Asset (unlevered) beta formula

A

βU = E/(E+D)βE + D/(E+D)βD

89
Q

Net debt

A

Net Debt = Debt − Excess Cash and short-term investments

90
Q

Operating leverage formula

A

Operating leverage = fixed cost / variable costs.

91
Q

WAAC

A

The effective after tax cost of capital of the firm

92
Q

Unlevered cost of capital

A

The unlevered cost of capital is the
expected return investors will earn
holding the firm’s assets.

93
Q

Weighted Average Cost of Capital (WACC) formula

A

𝑟𝑊𝐴𝐶𝐶 = 𝐸/(𝐸+𝐷)𝑟𝐸 + 𝐷/(𝐸+𝐷)𝑟𝐷*(1−𝑡𝑎𝑥)

94
Q

Under diversification

A

There is much evidence that individual investors fail to diversify their portfolios adequately

95
Q

Familiarity Bias

A

: Investors favour investments in companies with which they are familiar

96
Q

Relative wealth concerns

A

Investors care more about the performance of their portfolios relative to their peers

97
Q

Hanging on to losers and the disposition effect:

A

An investor holds on to stocks that have lost their value and sell stocks that have risen in value since the time of purchase

98
Q

Attention

A

Individuals are more likely to buy stocks that have recently been in the news and advertising, experienced exceptionally high trading volume, or have had extreme returns

99
Q

Mood

A

Sunshine generally has a positive effect on mood, and studies have found that stock returns tend to be higher when it is a sunny day at the location of the stock exchange

100
Q

Experience

A

Investors appear to put too much weight on their own experience rather than considering all the historical evidence. As a result, people who grew up and lived during a time of high stock returns are more likely to invest in stocks than are people who experienced times when stocks performed poorly

101
Q

Information cascade effect

A

: Traders ignore their own information hoping to profit form the information of others

102
Q

2) Relative wealth concers

A

Individuals choose to herd in order to avoid the risk of underperforming their peers

103
Q

Reputation risk

A

Professionals may face reputation risk if they stray too far from the actions of their peers

104
Q

size effect

A

Small market capitalization stocks have historically earned higher average return than the market portfolio, even after accounting for their higher beta

105
Q

Exess return and book-to-market ratio

A

: High book-to-market stocks have historically earned higher average returns than low book-to-book market stocks

106
Q

momentum strategy

A

Buying stocks that have had past high returns and (short) selling stocks that have had past low return.

107
Q

proxy

A

value for interest as that can not be measured

108
Q

Behaviour biases

A

By falling prey to be behavioural biases, investors may hold inefficient portfolios

109
Q

momentum strategy

A

Buying stocks that have had past high returns and (short) selling stocks that have had past low returns

110
Q

Multifactor models of risk:

A

E(Rs) = rf + betas(E(Rmrk)-rf) + beta * E(Rx1) + Beta E(Rx2) + beta * e(Rx3)

X1 = Market capitalization strategy
X2 = Book-to market ratio strategy
X3 = past return strategy
111
Q

Capital gain rate

A

P1-P0/P0

112
Q

Share price discounted cash flow model

A

(PV(FCF) + cash - debt) /shares outstanding

113
Q

Waac formula

A

(𝐸/𝐸+𝐷)𝑟(𝐸) + (𝐷/𝐸+𝐷)𝑟(𝐷)*(1−𝑡𝑎𝑥)

114
Q

What if the current stock price less than P0?

A

Then you may consider the stock is underpriced →
• people rush in and buy it ,
• And this market behaviour would drive up the stock’s price.

115
Q

dividend per share

A

Earnings/shares outstanding x dividend payout rate

116
Q

Change in earnings formula

A

New investment x Return on new investment

117
Q

Consequences of share repurchase

A

1) The more cash the firm uses to repurchase shares, the less it has available to pay dividends.
2) By repurchasing, the firm decreases the number of shares outstanding, which increases its earnings and dividends per share.

118
Q

Vn formula (Terminal value)

A

FCFn+1/rwaac-gfcf = ((1+gfcf)/(rwaac-gfcf)) x FCFn

119
Q

Vn formula (Terminal value)

A

FCFn+1/rwaac-gfcf = ((1+gfcf)/(rwaac-gfcf)) x FCFn

120
Q

Method of Comparables

A

Estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future.

121
Q

Enterprise value multiples

A

V0/EBITDA or FCF/EBITDA/rwaac-gfcf

122
Q

Limitations of multiples

A

First challenge: how to adjust for differences in expected future growth rates, risk, or differences in accounting policies.
2) Comparables only provide information regarding the value of a firm relative to other firms in the comparison set.
▪ Using multiples will not help us determine if an entire industry is overvalued.

123
Q

Capital market line

A

Investors’ optimal asset allocation line. Rational investors form their portfolio at CML.

124
Q

Effective after tax interest rate (formula)

A

r(1-Tc)

125
Q

Determine share price with forward P/E

A

P/E x EPS = share price

126
Q

Estimation of shareprice using price to book multiplier

A

Price/book (ratio) x book value = share price

127
Q

Marginal contribution to risk formula

A

SD x Corr

128
Q

correlation with sharpe ratio formula

A

corr = sharpe ratio/sharpe ratio

Finance & investment (2 decks)

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