FINA 3000 Exam 3 Slides

What are the two types of investment risk?

stand-alone risk and portfolio risk

Investment Risk

related to the probability of earning a low or negative actual return

The greater the chance of lower than expected, or negative returns, the ______ the investment.

riskier

Probability Distributions

a listing of all possible outcomes, and the probability of each occurrence

Probability distributions can be shown

graphically

Stocks are usually _______ than bonds.

riskier

T-bills are risky in terms of

reinvestment risk

Why do T-bills not provide a completely risk-free return?

they are still exposed to inflation

T-bills are risk-free in terms of

the default sense of the word; they will return the promised rate regardless of the economy

High Tech

moves with the economy, and has a positive correlation. this is typical.

Collections

is countercyclical with the economy, and has a negative correlation. this is unusual.

ˆr (r hat)

expected rate of return

standard deviation

Standard Deviation Formula

square root of variance

Standard Deviation

measures the total, or stand-alone, risk

The larger the standard deviation is, the _____ the probably that the actual returns will be closer to the expected returns.

lower

_______ standard deviation is associated with a wider probability of returns.

larger

Coefficient of Variation (CV)

a standardized measure of dispersion about the expected value, that shows the risk per unit of return

Sharpe Ratio

an alternative measure of stand-alone risk. it looks at excess return relative to risk.

How is risk measured in the sharpe ratio?

as the standard deviation of the asset’s return

A risk-free asset will have a sharpe ratio of

0

Risk Premium

the difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold their riskier securities

Risk Oversion

assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities

These stocks are

negatively correlated

These stocks are

perfectly positively correlated

These two stocks are

partially correlated

Stand-Alone Risk Formula

market risk + diversifiable risk

Market Risk

portion of a security’s stand-alone risk that cannot be eliminated through diversification

What is market risk measured by?

beta

Diversifiable Risk

portion of a security’s stand-alone risk that can be eliminated through proper diversification

Capital Asset Pricing Model (CAPM)

suggests that there is a Security Market Line (SML) that states that a stock’s required return equals the risk-free return plus a risk premium that reflects the stock’s risk after diversification

What is the primary conclusion of the capital asset pricing model?

the relevant riskiness of stock is its contribution to the riskiness of a well-diversified portfolio

What model links risk and required returns?

capital asset pricing model

Beta

measures a stock’s market risk, and shows a stock’s volatility relative to the market

What does beta indicate?

how risky a stock is if the stock is held in a well-diversified portfolio

If beta = 1.0, the security is

just as risky as the average stock

If beta > 1.0, the security is

riskier than average

If beta < 1.0, the security is

less risky than average

Most stocks have betas in the range of

0.5 to 1.5

Market Risk Premium

additional return over the risk-free rate needed to compensate investors for assuming an average amount of stock

The market risk premium is the potential to

gain more money by taking on additional risk

While it varies from year to year, most estimates suggest that the market risk premium ranges between

4% to 8%

The size of the market risk premium depends on

the perceived risk of the stock market and investors’ degree of risk aversion

Facts about common stock

represents ownership, ownership implies control, stockholders elect directors, directors elect managers

What is management’s goal?

maximize the stock price

What dictates control of the corporation?

voting rights

Proxy

a document that allows someone to act on another’s behalf (power to vote)

Proxy Fight

attempt to gather enough votes to replace management

Takeover

successful ouster of a firm management and the taking of control of a corporation

Pre-emptive Rights

gives common stockholders the ability to acquire new issued shares on a pro rata basis

What is the purpose of pre-emptive rights?

prevents management self-dealing, reduces dilution of value

What can be defenses of a takeover?

change in seats elected per year, increased % required to approve a merger, poison pill - reduced cost of stock in the acquiring firm

Common Shares

often include voting, may be different classes

Preferred Shares

often are convertible, without voting

Founders’ Shares

control maintained by founders without necessity of majority of shareholding

Intrinsic Value

what the company is actually worth (looking at things owned and owed)

Stocks with a price equal to its intrinsic value are

at equilibrium

Stocks with a price below to its intrinsic value are

undervalued

Stocks with a price above to its intrinsic value are

overvalued

The value of a stock is the

present value of the future dividends expected to be generated by the stock

Constant Growth Stock

a stock whose dividends are expected to grow forever at a constant rate, g

The corporate valuation model is also called the __________ model.

free cash flow

Corporate Valuation Model

suggests the value of the entire firm equals the present value of the firm’s free cash flows (which is the MV of its operations) plus the market value of its non-operating assets

Free Cash Flow

the firm’s after-tax operating income less the net capital investment