MBA 6110 - Test 1

Dollar Return

The total currency gain or loss generated from an investment, including capital changes and any cash income received.

Percentage Return

The investment gain or loss divided by the original investment amount, expressed relative to the initial outlay.

Expected Return

The probability-weighted average of all possible future outcomes for an investment.

Expected Return Formula

$$E(r) = \sum (P_i \times r_i)$$

Stand-Alone Risk

The total risk an investor faces when holding an individual asset in isolation rather than in a portfolio.

Variance (in Finance)

A statistical measure of dispersion indicating how far possible returns spread from the expected return, calculated using squared deviations.

Standard Deviation (in Finance)

The square root of variance, utilized as the primary metric for measuring stand-alone risk.

Effect of an Increase in Standard Deviation on Risk

Stand-alone risk increases because possible returns are more widely dispersed.

Diversification

The strategy of combining various investments within a single portfolio to reduce total risk.

Market Risk (Systematic Risk)

The non-diversifiable risk that stems from broader macroeconomic forces and affects the entire market.

Diversifiable Risk (Unsystematic Risk)

The firm- or industry-specific risk that can be eliminated through portfolio diversification.

Total Risk Relationship Formula

$$\text{Stand-Alone Risk} = \text{Market Risk} + \text{Diversifiable Risk}$$

Effect of Adding More Random Stocks to a Portfolio

Diversifiable risk decreases toward zero, while systematic market risk remains unchanged.

Can Diversification Eliminate Market Risk?

No, because market risk stems from macroeconomic factors that influence all securities across the economy.

Correlation Coefficient

A standardized statistical measure ranging from $-1$ to $+1$ that indicates how closely two assets' returns move in tandem.

Correlation of $+1$ (Perfect Positive Correlation)

Asset returns move in identical lockstep, providing zero diversification benefit when combined.

Correlation of $-1$ (Perfect Negative Correlation)

Asset returns move in opposite directions, allowing a properly weighted portfolio to eliminate all risk.

Correlation Between $-1$ and $+1$

Diversification reduces portfolio risk relative to the weighted average of individual risks, but cannot eliminate all risk.

Portfolio Expected Return

The weighted average of the expected returns of the individual assets comprising the portfolio.

Portfolio Return Formula

$$r_p = \sum (w_i \times r_i)$$

Beta ($\beta$)

A metric that quantifies an asset's systematic or non-diversifiable risk relative to the overall market portfolio.

Implication of $\beta = 1$

The asset moves directly in line with the market and carries the same degree of systematic risk.

Implication of $\beta > 1$

The asset exhibits greater systematic risk and volatility than the broader market average.

Implication of $0 < \beta < 1$

The asset moves in the same direction as the market but with less systematic risk and lower volatility.

Implication of $\beta = 0$

The asset carries zero systematic exposure to broader market movements (e.g., a risk-free security).

Impact of an Increase in Beta on Required Return

Required return increases under the Capital Asset Pricing Model, provided the market risk premium is positive.

Portfolio Beta Formula

$$\beta_p = \sum (w_i \times \beta_i)$$

Capital Asset Pricing Model (CAPM)

A financial framework establishing the required rate of return for an asset based on its systematic risk ($\beta$), the risk-free rate, and the market risk premium.

CAPM Formula

$$r_i = r_{RF} + \beta_i \times (r_M - r_{RF})$$

Market Risk Premium

The additional expected compensation required for bearing average market risk beyond the risk-free rate, calculated as $r_M - r_{RF}$.

Impact of an Increase in the Market Risk Premium

The required return increases for all assets with a positive beta, holding all other variables constant.

Security Market Line (SML)

The graphical line representing the Capital Asset Pricing Model, plotting required return against systematic risk ($\beta$).

Weak-Form Market Efficiency

The condition where market prices already reflect all past trading and price history, rendering technical analysis ineffective.

Semistrong-Form Market Efficiency

The condition where asset prices reflect all publicly available information, rendering both technical and fundamental analysis ineffective for achieving abnormal returns.

Strong-Form Market Efficiency

The condition where asset prices reflect all available information, including private and insider knowledge, preventing any participant from earning abnormal profits.

The Most Stringent Form of Market Efficiency

Strong-form efficiency, because it encompasses historical, public, and private insider information within current market prices.

Key Difference Between Beta and Standard Deviation

Beta measures non-diversifiable systematic risk relative to the market, whereas standard deviation measures total stand-alone risk.

Common Stock

Equity securities representing proportional ownership in a corporation, giving holders residual claims on assets and dividends.

Corporate Directors (Election)

Elected directly by common stockholders to oversee company governance and represent shareholder interests.

Corporate Management (Selection)

Appointed and monitored by the board of directors to manage day-to-day operations.

Primary Financial Goal of Management

To maximize shareholder wealth through the maximization of the stock price.

Determinants of Stock Intrinsic Value

The present value of expected future cash flows, such as dividends, discounted at the required rate of return.

Constant-Growth Dividend Model (Gordon Growth Model)

A stock valuation method assuming dividends grow at a constant rate indefinitely.

Constant-Growth Stock Valuation Formula

$$P_0 = \frac{D_1}{r_s - g}$$

Dividend at Time Zero ($D_0$)

The dividend that was just paid to investors.

Dividend at Time One ($D_1$)

The dividend expected to be paid in the upcoming period.

Relationship Between $D_0$ and $D_1$ Formula

$$D_1 = D_0 \times (1 + g)$$

Impact of an Increase in Required Return on Stock Price

Stock price decreases, holding expected dividends constant.

Impact of a Decrease in Required Return on Stock Price

Stock price increases, holding expected dividends constant.

Impact of an Increase in Dividend Growth Rate on Stock Price

Stock price increases under the constant-growth model, holding the expected dividend and required return constant.

Impact of an Increase in Expected Future Dividends on Stock Price

Stock price increases, holding the required return constant.

Requirement That $g < r_s$ in the Constant-Growth Model

If $g \ge r_s$, the perpetual constant-growth formula cannot produce a finite, positive stock value.

Dividend Yield

The expected annual dividend for the upcoming period divided by the current stock price.

Dividend Yield Formula

$$\text{Dividend Yield} = \frac{D_1}{P_0}$$

Capital Gains Yield

The percentage rate of return generated from a change in the stock price over a given period.

Capital Gains Yield Formula

$$\text{Capital Gains Yield} = \frac{P_1 - P_0}{P_0}$$

Capital Gains Yield Under Constant Growth

Equal to the constant dividend growth rate ($g$).

Total Stock Return Formula

$$\text{Total Return} = \text{Dividend Yield} + \text{Capital Gains Yield}$$

Required Return Formula Under Constant Growth

$$r_s = \frac{D_1}{P_0} + g$$

Impact of an Increase in Dividend Yield on Required Return

Required return increases, assuming the growth rate remains constant.

Nonconstant Dividend Growth

A period where dividends grow at unequal or above-normal rates before eventually stabilizing into perpetual constant growth.

Valuation Process for a Nonconstant-Growth Stock

Forecast dividends during nonconstant growth, calculate the horizon value once constant growth begins, and discount all values back to the present.

Horizon Value (Terminal Value)

The value of expected future cash flows at the specific point in time where constant growth begins.

Stock Horizon Value Formula

$$P_t = \frac{D_{t+1}}{r_s - g}$$

Reason Horizon Value Must Be Discounted

It reflects the market value of cash flows at a future time period rather than at time zero.

Free Cash Flow (FCF)

Cash flow generated by core operations that remains available to all capital providers after paying operating expenses, taxes, and necessary capital investments.

Free Cash Flow Valuation Model

A methodology that estimates the total value of operations by discounting expected future free cash flows to the present.

Discount Rate for Free Cash Flow Valuation

The Weighted Average Cost of Capital (WACC), because free cash flow is available to satisfy all suppliers of capital.

Corporate Horizon Value Formula

$$\text{HV}_t = \frac{\text{FCF}_{t+1}}{\text{WACC} - g}$$

Impact of Higher FCF Growth on Operating Value

Operating value increases when expected cash flows grow faster, holding WACC constant.

Impact of an Increase in WACC on Operating Value

Operating value decreases because future cash flows are discounted at a higher rate.

Preferred Stock

A hybrid security possessing fixed income characteristics of bonds alongside equity ownership features of common stock.

Bond-Like Characteristic of Preferred Stock

It typically pays a fixed periodic dividend stream.

Key Difference Between Preferred Stock and Bonds

Missing dividend payments does not automatically force a company into legal bankruptcy, unlike defaulting on debt obligations.

Dividend Priority Order: Preferred vs. Common Stock

Preferred shareholders hold priority and must receive their stated dividends before any payments can be made to common shareholders.

Cumulative Preferred Stock

A share class where any omitted or skipped dividends accumulate and must be paid in full prior to any common stock distributions.

Preferred Stock Valuation Formula

$$V_{ps} = \frac{D_{ps}}{r_{ps}}$$

Cost of Capital

The required return a firm must provide to investors who supply financing.

WACC (Acronym Meaning)

Weighted Average Cost of Capital.

Weighted Average Cost of Capital (WACC)

The overall financing cost of a firm calculated as the weighted average of its debt, preferred stock, and common equity components.

WACC Formula

$$\text{WACC} = w_d \times r_d \times (1 - T) + w_{ps} \times r_{ps} + w_s \times r_s$$

Cost of Debt

The return lenders require on a company's borrowed funds.

Cost of Common Equity

The return common stockholders require for investing in a company.

Cost of Preferred Stock

The return preferred stockholders require for providing financing to the company.

Role of Yield to Maturity (YTM) in Debt Financing

The current before-tax cost of debt for an existing bond, assuming it reflects the market's required yield.

After-Tax Cost of Debt

The effective cost of borrowing after accounting for the tax deduction on interest payments.

After-Tax Cost of Debt Formula

$$r_d \times (1 - T)$$

Impact of an Increase in the Corporate Tax Rate on the After-Tax Cost of Debt

It decreases, assuming the before-tax cost of debt remains constant.

Impact of a Decrease in the Corporate Tax Rate on the After-Tax Cost of Debt

It increases, assuming the before-tax cost of debt remains constant.

Reason Debt Is Multiplied by $(1 - T)$ in the WACC Formula

Because interest payments are tax-deductible expenses, generating an interest tax shield for the firm.

Reason Preferred Stock Is Not Tax-Adjusted in the WACC Formula

Preferred dividends are paid out of net income and are not tax-deductible for corporations.

Reason Common Equity Is Not Tax-Adjusted in the WACC Formula

Common dividends and capital gains are paid from after-tax earnings and cannot be deducted as corporate interest expenses.

Capital Structure Weights

The proportional shares of financing contributed by debt, preferred stock, and common equity.

Required Sum of All Capital Structure Weights

$100\%$ (or $1.0$).

Book Value Weights

Capital structure proportions calculated using historical balance-sheet accounting values.

Market Value Weights

Capital structure proportions calculated using current market valuations of outstanding securities.

Target Capital Structure Weights

The specific financing proportions a firm intentionally strives to maintain over the long term.

Capital Structure Weights Reflecting Current Financing Conditions

Market value weights.

Reason Book Value Weights Differ from Market Value Weights

Book values record historical accounting costs, whereas market values reflect current investor expectations and prevailing prices.

Book Value of Common Equity Formula

$$\text{Common Stock} + \text{Retained Earnings}$$