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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)
