MGT 181 Final Exam

total risk

standard deviation of a stock's returns

systematic and unsystematic

for well-diversified: unsystematic risk very small

total risk for diversified portfolio is essentially = systematic risk

total return

expected return + unexpected return

systematic risk

market risks - unanticipated events that affect almost all assets to some degree

-->

MEASURED BY BETA

risk factors that affect large number of assets

aka non-diversifiable or market risk

includes things like GDP, inflation, interest rates, presidential elections

unsystematic risk

unique or asset specific - unanticipated events that affect single assets of small groups of assets

-->

risk factors that affect limited number of assets

aka unique risk and asset specific risk

includes labor strikes, part shortages, etc.

effect of diversification

some but not all of the risks associated with a risky investment can be eliminated by diversification (not putting all eggs (investment) into one basket

systematic risk principal and beta

the reward for bearing risk depends only on the level of systematic risk (you can diversify away unsystematic risk)

level of systematic risk in a given asset, relative to average, is given by the *Beta* of that asset

Harry Markowitz

Father of Modern Portfolio Theory

further developed by William Sharpe and Merton Miller

Modern Portfolio

basis of modern financial management

reward to risk ratio

ratio of its risk premium to its beta

all assets plot on same line: the security market line (SML)

risk premium: (E(Ri)-Rf))

Capital Asset pricing Model (CAPM)

From the SML, the expected return on asset (i) can be written: E(Ri)=Rf + [E(RM)- Rf] x Beta

risk free + beta (market - risk-free)

unexpected returns

can be pos or neg

over time, avg = 0

affects stock price and its return

efficient markets

result of investors trading unexpected portion of announcements

the easier it is to trade on surprises, more efficient markers should be

involve random prices because cannot predict surprises

unexpected return

systematic portion+unsystematic portion

portfolio

collection of assets

asset risk and return important-->affect risk and return of portfolio

risk-return trade-off measured by *portfolio expected return and standard deviation*

standard deviation

very spread out, returns uncertain

close, returns more certain

expected return on portfolio

sum of: expected return of each asset multiplied by their weight

portfolio diversification

investment in several different asset classes or sectors

like investments in many different industries; not just 100 stocks in one industry

diversification

greatly reduce variability of returns without reducing expected returns

systematic portion cannot be diversified away

diversifiable risk

risk that can be eliminated by combining assets into a portfolio

aka unsystematic, unique, asset-specific risk

beta coefficient

= 1 --> asset has same systematic risk as overall market

< 1 --> asset has less systematic risk than overall marker

> 1 --> asset has more systematic risk than overall market

portfolio beta

sum of: weight x beta

risk premium

expected return - risk-free rate

the higher the beta, the greater the risk premium should be

can use risk premium and best to guess the --> expected return

risk-to-reward ratio

beta to expected return graph

Slope = (E(RA) - Rf) / (BetaA - 0)

market equilibrium

E(RA)-Rf/Beta = E(RM-Rf)/BetaM

assets and portfolios must have same reward-to-risk ratio

must =

reward-to-risk ratio for market

security market line (SML)

Slope = E(RM) - Rf = market risk premium

beta of market always = 1

required return on asset

risk free + beta x (market - risk-free)

reward/risk ratio

(required return on asset - risk-free) / beta

required return on portfolio

(% asset x required return on asset) + (other % x market)

expected returns

based on probabilities of possible outcomes

sum of: probability x return

risk premium (equation)

required - risk-free

why cost of capital important

return on assets depends on the risk of those assets

(higher risk=higher reward)

return to investor = cost to the company

cost of capital = how the market views the risk of company

cost of capital can tell us required return for budgeting projects

required return (concepts)

same as discount rate, based on the risk of cash flows

need to know required return on investment before getting the NPV

need to earn at least required return to compensate investors (who financed)

cost of equity (concepts)

return required by equity investors (pertains to risk on cash flows from firm)

-business risk

-financial risk

two major methods to determine cost of equity

-dividend growth model

SML or CAPM

dividend growth model

cost of equity (RE) = dividend / price of stock + growth

dividend growth model for cost of equity (concepts)

pro: easy to understand and use

con: only to companies paying dividends

doesn't apply if dividends aren' growing at constant rate

sensitive to estimated growth rate

does not really consider risk

SML for cost of equity (concepts)

in slide:

cost of equity = risk-free + beta(market)

pro:

adjusts for systematic risk

applies to all companies

con:

estimate market risk premium

estimate beta

using past to predict future (not always good)

cost of debt

required return on company's debt

cost of long term or bonds

best to compute yield to maturity

use current rates to issue new debt

international fisher effect

real rate of returns constant across all countries

home currency approach

estimate cash flow in foreign country

est future exchange rate with UIP or PPP

convert to dollars

discount in dollars

foreign currency approach

est cash flow in foreign currency

use IFE to convert domestic required return to foreign required return (compare the two)

discount with foreign

convert to NPA to dollars using current spot rate

spot trade

exchange currency immediately

spot rate

exchange rate for immediate trade

forward exchange

agree today o exchange currency at some rate and time in future

forward rate

exchange rate specified in forward contract

forward rate > spot rate

foreign currency is selling at PREMIUM

forward rate < spot rate

selling at DISCOUNT

absolute PPP (purchasing power parity)

price of item should be same in real terms regardless of currency used to purchase it

trans costs 0

no barriers o trade (taxes, tariffs, etc)

no difference in commodity between locations

RARELY HOLDS IN PRACTICE

exchange rate (equation)

current (time 0) spot exchange rate [(1+(inflation rate of foreign-inflation rate of US)]

FOREIGN CURRENCY PER DOLLAR

carry trade

borrow low yielding currencies and invest in high yielding currencies

risk free rate

R US

T-bill rate

arbitrage opportunity

borrow 100 at 4%

buy $100(0.8 E/$)=81.6 Euro and invest at 2% for 1 year

in 1 year

receive 80(1.02)=81.6 E and convert to US

116.57 and repay loan

$100(1.04)=104

profit= $12.57 risk free

interest rate parity

=spot exchange rate[(risk free rate of foreign-risk free rate of US)]

unbiased forward rates

current forward rate is an unbiased est of future spot rate

on average FORWARD RATE = FUTURE SPOT RATE

repatriated cash flow

some cash generated from foreign project must remain in foreign country due to restrictions on repatriation

can occur by:

-dividends to parent company

-management fees for central services

-royalties on use of trade names and patents

short run exposure

risk from day to day fluctuates; have contracts to buy/sell goods in short-run

managing risk

enter forward agreement

use foreign currency to lock in exchange rates if they move against you, benefit from rate if they move in your favor

long run exposure

long run fluctuation comes from unanticipated changes in relative econ conditions

changes in market or government

try to match long run in/outflow

borrow from foreign country to mitigate

translation exposure

income from foreign operations must be translated back to US dollars (even if isn't actually converted)

gains and losses from translation flowed through directly through income statement --> affects the EPS

existing accounting regulation require that all cash flows be converted prevailing exchange rates with currency gains and losses accumulated in special account within equity

managing exchange risk

manage with several different countries

consider exposure to currency risk, instead of just looking at each currency separately

hedgin currencies could be expensive, may actually increase exposure

political risk

unstable governments=should require higher returns

the bidder

the acquiring firm

target firm

firm that is sought

consideration

cash or securities offered to target firm in acquisition

merger

one firm is acquired by another

2nd firm DOES NOT EXIST

much be approved by both firms

tender offer

public offer to buy shares made directly by bidder to target firm shareholders

horizontal

same industry

vertical

diff stages of production process

conglomerate

firms are unrelated

takeover

control goes from one group to another

after tax cost debt

RD(1-tc)

WACC

WE RE + WDRD(1-TC)

treat preferred separate

add on to equity section (with common stock)

PMT

coupon rate x 1000

divide by 2 if semiannual

pure play approach

compute beta for each company

take avg

use beta with CAPM to find return for project

subjective approahch

consider risk to overall firm

if project risk higher than first, use discount rate greater than WACC

if less risky than firm, use discount rate lower than WACC