Business Finance Exam 2

In an efficient market if investment A has a standard deviation of 6.25% and investment B has a standard deviation of 9.75%, we know what about these two investments?

Investment B has more total risk than A

The higher compensation an investor seeks to obtain for carrying more risky assets is known as what?

Risk premium

What is another term for the % HPR

Nominal return

always keep returns expressed as

percentages

always keep weights/probabilities expressed as

decimal

the expected return on an asset depends only on that asset’s

market risk (systematic risk)

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

greater

What does the MRP measure

excess risk

the geometric average can overestimate/underestimate for short time periods

underestimate

What does EMH imply

that you will earn a return appropriate for the level of risk

T/F: you can only estimate the cost of equity

true

the DDM is only applicable to companies who are….

currently paying dividends AND that are growing at reasonably constant rate

T/F: the DDM is not sensitive to the growth rate

false

What does WACC stand for?

Weighted Average Cost of Capital

For equity (stock) the cash flow an investor receives is called a _______

Dividend

True/false: dividends are guaranteed for stocks

False

What is the dividend discount model (DDM) similar to?

Perpetuity

What is the Punsy scheme

if potential investors never expect a company to pay a dividend, their value = 0

When is the dividend discount model used

to price any stock as long as we expect a dividend to be paid at some point in the future

Can the growth rate (g) be zero or negative?

yes, the company may pay a set dividend every year

Can the stock still be priced if g > r?

Yes, just means that they are a fast growing company

What does r stand for in the DDM

discount rate or market capitalization rate - expected return to the investor

What does g stand for in the DDM

growth rate of dividends - also translates to growth of firms (capital gains yield)

Return = ______ + _______

Dividend yield + capital gains yield

What is terminal value

value of the company as going concern in the future (perpetual)

In DDM, we can see that the return on a stock can be decomposed into _______ yield and _______ yield

dividend and capital gains

You can’t used the DDM formula without D1, and you can’t find D1 without ______

growth rate

Holding Period Return (HPR)

total return for an asset over the entire period the asset was held

% HPR formula has similar format as _______

required returns “r”

Based on the assumption that returns follow a normal distribution, we can use standard statistics to make some assumptions about the ________

return of the asset

What measures the total risk of returns

Standard deviation

Geometric Average will always be greater/less than regular mean

less

What does the geo mean consider that the regular mean does not

compounding

U.S. Stock market is between which two forms of EMH?

Semi-strong and strong form

States of Economy

Anticipating future conditions and assigning probabilities to each scenario. (We then select assets and estimate returns based on the likelihood of each economic state occurring, helping us calculate our expected return.)

T/F: expected returns are weighted averages

True

Weighted averages are weighted by

the probability of our expectations of the economic state

What needs to be calculated first when dealing with states of economy with a portfolio?

Expected return of the portfolio in each state

T/F: the standard deviation of a portfolio is a weighted average of the individual asset risk

false

Why is diversification important in a portfolio?

helps reduce overall risk (firm-specific risk)

As we increase the assets held in the portfolio, we can increase/decrease exposure to firm-specific risks

decrease

What does CAPM stand for?

Capital Asset Pricing Model

What does CAPM say about investors

they are only rewarded for bearing market risk, not firm-specific risk, since it can be diversified.

What does beta represent

measure of the asset’s market risk

T/F: the expected return of an asset is a linear equation

true

What does it mean when B > 1

risky

What does it mean when B < 1

not as risky

Security Market Line (SML)

all assets should have returns on the line (as long as they are priced correctly)

If an asset is overpriced, it is above/below the line

below (you pay more so the return is lower)

If an asset is underpriced, it is above/below the line

above (you pay less so the return is higher)

the weights in the WACC formula are based on what value?

market value

What are the 3 sources of capital

common equity, preferred equity, Debt

Market Capitalization =

MV of equity

T/F: Debt provides a tax shield as you won’t be taxed on interest

True

What is another name for after-tax

effective

What is Ke (concept)

Expected return that owners of common or preferred stock have

How do you estimate the Ke?

DDM or CAPM