FIN-350 Exam 4

Overall Performance Measure

Summarizes past investment performance

Weighted Average Cost of Capital

Calculated based on market values for components

Percentage Return Calculation

Method: divide $ return by investment's beginning value

Average Monthly Return

Calculated as the mean of monthly returns

Risk Ranking

Order from least to most risky assets

Total Risk Definition

Portion of risk attributable to firm or industry factors

Risk-Return Relationship Ranking

Ordering stocks based on return and standard deviation

Diversifiable Risk

Part of total risk reducible through diversification

Portfolio Return Calculation

Weighted sum of individual asset returns in a portfolio

Portfolio Weights Calculation

Individual stock weight in a portfolio

Expected Return Calculation

Weighted sum of returns based on probabilities

Market Risk Premium

Reward for taking systematic stock market risk

Company's Required Return Calculation

Based on beta, market return, and risk-free rate

Asset Pricing Theory Basis

Relies on beta as a measure of market risk

Efficient Market Hypothesis

States security prices reflect expected return

Behavioral Finance Study

Focuses on biases in financial decision-making

Expected Return Calculation (Equation 10.6)

Formula: D1/P0 + growth rate

Executive Stock Options

Special rights to buy company shares at a fixed price

Component Cost of Preferred Stock

Calculated as coupon rate divided by price

Cost of Equity Calculation

Based on beta, risk-free rate, and market return

Component Cost of Debt Calculation

Before and after-tax costs based on bond details

Firm's Value-Adding Project Analysis Start

Begins with current capital structure and costs

Firm's Cost of Capital Basis

Determined by weighted average of debt and equity costs

Risk and Return Relationship

Historical data shows a positive correlation between risk and return.

Diversification

Owning various stocks in a portfolio to mitigate firm-specific risk.

Market Risk

Risk associated with stock ownership beyond firm-specific risk.

CAPM

Capital Asset Pricing Model that uses Beta to measure market risk.

Expected Return

Forward-looking calculation based on return probabilities and their likelihoods.

Standard Deviation

Measure of stock risk based on historical returns' variability.

Risk Premium

Part of expected return comprising risk-free rate and return premium.

Market Risk Premium

Reward for taking general stock market risk.

Efficient Frontier

Portfolio combinations offering highest return for each risk level.

Financial Leverage

Borrowing money to invest, increasing portfolio risk.

Security Market Line

Relates required return to risk, considering market portfolio's risk premium.

Company Risk Premium

Risk premium calculation for a specific company like Netflix.

Stock Market Bubble

Inflated market leading to dramatic price collapse.

Portfolio Beta

Weighted average of individual stock betas in a portfolio.

Efficient Market

Securities market where prices reflect all available information on each security

Efficient Market Hypothesis (EMH)

Theory that security prices fully reflect all available information

Executive Stock Options

Special rights for corporate executives to buy company stock at a fixed price

Market Portfolio

Theoretical combination of securities placing a portfolio on the efficient frontier

Overconfidence

Tendency to overestimate knowledge and underestimate risks

Penny Stocks

Stocks of small companies priced below $1 per share

Behavioral Finance

Study of cognitive biases in financial decision-making

Restricted Stock

Shares issued to employees with limitations on sale

Capital Asset Pricing Model (CAPM)

Model specifying the relationship between required return and risk

Capital Market Line (CML)

Line on a graph of return and risk through the market portfolio

Beta (β)

Measure of sensitivity of a stock or portfolio to market risk

Asset Pricing

Process of specifying the relationship between required return and risk

Constant-Growth Model

Alternative to CAPM for computing shareholders' required return

Diversifiable Risk

Risk that can be reduced through diversification

Non-diversifiable Risk

Risk that cannot be eliminated through diversification

Modern Portfolio Theory

Concept of combining securities into a portfolio to minimize risk

Risk

Volatility of an asset's returns over time

Standard Deviation

Measures deviation from the average return

Total Risk

Combination of firm-specific risk and market risk

Coefficient of Variation

Measures risk taken per 1% return achieved

Efficient Frontier

Set of dominating portfolios with highest return for desired risk

Modern Portfolio Theory

Combining securities to minimize risk and maximize returns

Market Risk

Total risk attributed to overall economic factors

Diversification

Reduces firm-specific risk by owning many investments

CAPM

Calculates required return using beta, market return, and risk-free rate

Expected Return

Computed return based on economic states and likelihoods

Required Return

Minimum return an investor expects for an investment

Risk Premium

Excess return expected for taking on additional risk

Risk

Choice rather than fate, actions dependent on freedom to choose

Dollar Return

Profit or loss from an investment denoted in dollars

Percentage Return

Dollar return as a percentage of money invested

Geometric Mean Return

Equivalent return compounded for N periods

Volatility

Measure of past return risk or uncertainty

Standard Deviation

Square root of the average squared deviation of returns

Portfolio

Combination of investment assets held by an investor

Non-diversifiable Risk

Portion of total risk due to economic factors

Optimal Portfolio

Portfolio combining securities to minimize risk

Market Risk

Volatility of an investment due to economic factors

Modern Portfolio Theory

Concept for combining securities to minimize risk

Coefficient of Variation

Relative measure of risk-vs-reward relationship

Variance

Measure of dispersion in a set of values

Diversification

Reducing overall risk by investing in different assets

Efficient Frontier

Set of portfolios with maximum expected return for each risk level

Correlation

Measurement of co-movement between variables, ranges from -1 to 1

Firm-specific Risk

Risk attributable to firm or industry factors, can be reduced through diversification

Portfolio Weight

Proportion of a stock in a portfolio, represented by a percentage

Portfolio Return

Return from portfolio securities and their proportions in the portfolio

Average Returns

Summarizes past performance of an investment

WACC Formula

Average cost per dollar of capital raised

Tax Cut and Jobs Act (TCJA) of 2017

Reduced corporate tax rates to 21%

Equity/Pref Stock/Debt

Types of capital in WACC calculation

Unconstrained Scenario

All debt interest fully tax deductible

Fully Constrained Scenario

Tax shield on new debt unlikely to be realized

Market Value of Equity (E)

Percentage of financing that is equity

Market Value of Preferred Stock (P)

Percentage of financing that is preferred stock

Market Value of Debt (D)

Percentage of financing that is debt

Cost of Equity (ie)

Equity financing cost in WACC

Cost of Preferred Stock (ip)

Preferred stock financing cost in WACC

Before-tax Cost of Debt (iD)

Debt financing cost before taxes in WACC

Marginal Corporate Tax Rate (Tc)

Tax rate used in WACC calculation

Component Cost of Equity

Methods: CAPM or constant-growth model

Component Cost of Preferred Stock

Special case of constant-growth model

Component Cost of Debt

Calculated using yield to maturity (YTM)