Topic 2 - return concepts

Question 1

What is the holding period return

Answer 1

HPR is the return earned from investing in an asset over a specified time

Question 2

what does HPR mean (formula)

Answer 2

Dividend yield + capital gain yield

Question 3

what is required return

Answer 3

THE MINIMUM LEVEL OF EXPECTED RETURN

Question 4

what does expected alpha = expected return - required return mean

Answer 4

Expected abnormal return = intrinsic value - market price

Question 5

what is equity risk premium

Answer 5

ERP is the incremental return investors expect above the risk free rate for taking risk

Question 6

What estimation approaches are there

Answer 6

1. Historical estimates

2. forward looking

Question 7

what is the formula for erp

Answer 7

erp = mean value of (equity market return - risk free return)

Question 8

what are issues when using historical estimates

Answer 8

1. equity index to represent equity market returns
2. the time period of computing the estimate
3. the type of mean calculated
4. the proxy for risk free return

Question 9

what are issues when using historical estimates

issues with equity index to represent equity market returns

Answer 9

broad-based, market value weighted indexes are typically selected. Survivorship bias - poorly performing companies are removed

Question 10

what are issues when using historical estimates

the time period of computing the estimate

Answer 10

extending the length to increase precision

including the distant past is hard to maintain the stationarity assumption

balance long term or short term choice

Question 11

what are the two types of means and how can they effect results

Answer 11

Arithmetic - affected by extreme data

Geometric - more accurately provides the compounded future value of an investment

Question 12

what are issues when using historical estimates

the proxy for the risk free return

Answer 12

• corporate bonds or government bonds
• short term treasury bills of long term government bonds
• match duration of the risk free rate measure to the duration of investment
• in practice, use recently issued government bonds because it is the most liquid
• the mainstream choice - geometric mean
  relative to long term government bonds

Question 13

Which mean should you favour for erp and why

Answer 13

Arithmetic as the average one-period return best represents the mean return ina single period. THe typical reason to favour this is the type of model in which the estimates are used and the other relating to a statistical property

Question 14

What is the Gordon growth model GGM

Answer 14

The Gordon Growth Model is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate.

Its a popular and more straight forward version of DDM

Question 15

What is the formula for GGM risk premium

Answer 15

GGM Risk Premium = Forecasted dividend yield on a market index + Forecasted LT earnings growth rate - LT government bond yield

Question 16

What are the assumptions of GGM

Answer 16

1. Earnings, dividends, and prices are expected to grow at the same rate

This implies the constant dividend payout ratio and P/E ratio

Question 17

What is the logic of GGM assumptions

Answer 17

earnings growth rate determines the capital gain because stock price will grow at same rate as earnings.

Most appropriate for mature developed markets

Question 18

What is formula for CAPM

Answer 18

E(Ri) = Rf + Bi[E(Rm) - Rf]

Question 19

Calculate CAPM required return

Current Rf 4.7%
Beta 1.04
Market risk Prem 5.5%

Answer 19

4.7%+1.04x5.5%

Question 20

Systematic risk Definition

Answer 20

Uncertainty inherent to the entire market

Question 21

Unsystematic risk

Answer 21

uncertainty peculiar to an individual security

Question 22

How can diversification effect systematic risk

Answer 22

cannot be eliminated by diversification

Question 23

How can diversification effect unsystematic risk

Answer 23

can be eliminated by diversification

Question 24

what is a measure of systematic risk

Answer 24

Beta

Question 25

what is a measure of unsystematic risk

Answer 25

error item

Question 26

What does unlevered beta mean

Answer 26

the risk of an unlevered company relative to the risk of the market

Question 27

what does levered beta mean

Answer 27

the risk of the company with equity and debt in its capital structure relative to the risk of the market

Question 28

What is the formula for fama-french model

Answer 28

Current risk free return +Betamarket risk premium + Size betasize risk premium + value beta* value risk premium

Question 29

how is pastor-stambaugh model (2003) different to the fama-french model

Answer 29

its the same but has a fourth factor of beta to illiquid stocks and market return to illiquid stocks

Question 30

Name four types of risk premiums

Answer 30

1. Size
2. Frim-specific (underlying assumption is risk is difficult to be diversified away)
3. lack of marketability
4. Controlling or minority interests

Question 31

What is the WACC formula

Answer 31

Value of debt * YTM of LT bond + (1-tax rate) + Value of equity * (Rf+beta * Equity risk premium)

Question 32

What choice of discount rate do you use when

1. CF to the firm
2. CF to equity
3. Nominal CF
4. Real CF

Answer 32

1. WACC
2. Required return on equity
3. Nominal discount rates
4. Real discount rate

Question 33

How to estimate a beta for a non traded company

Answer 33

1. Select the comparable benchmark
2. Estimate benchmarks beta
3. Unlever benchmarks beta
4. Lever the beta to reflect the subject company’s financial leverage