test 1 -fuller

What is expected return?

The average return expected from an investment based on probabilities. Multiply each possible return by its probability and add them together.

What is standard deviation?

A measure of total stand-alone risk. Higher standard deviation means more risk because returns vary more.

What is diversification?

Spreading investments across different assets to reduce company-specific risk.

What is the difference between market risk and company-specific risk?

Market risk affects the overall market and cannot be diversified away. Company-specific risk can be reduced through diversification.

What is beta?

A measure of a stock's market risk compared with the overall market.

What do different betas mean?

Beta = 1: same market risk as the market. Beta > 1: more market risk. Beta between 0 and 1: less market risk. Beta = 0: no systematic market risk.

If beta increases, what happens to required return?

Required return increases, assuming the market risk premium is positive.

What is CAPM?

A formula used to calculate the return investors require for taking market risk.

What is the CAPM formula?

Required Return = Risk-Free Rate + Beta × Market Risk Premium.

What is the market risk premium?

Market Return - Risk-Free Rate.

If the market risk premium increases, what happens to required return?

Required return increases for positive-beta stocks.

What is portfolio beta?

The weighted average beta of all the investments in a portfolio.

How do you calculate portfolio beta?

Multiply each stock's beta by its portfolio weight, then add the results.

What is the difference between beta and standard deviation?

Beta measures market risk. Standard deviation measures total risk.

What does correlation tell you about diversification?

Correlation of +1 means no diversification benefit. Correlation of -1 means properly weighted investments can eliminate portfolio risk.

What determines a stock's value?

The present value of the dividends investors expect to receive in the future.

What is the difference between D0 and D1?

D0 is the dividend just paid. D1 is the dividend expected next year.

How do you calculate next year's dividend?

D1 = D0 × (1 + Growth Rate).

What is constant dividend growth?

When dividends grow at the same rate every year forever.

What is the constant-growth stock price formula?

P0 = D1 / (Required Return - Growth Rate).

If required return increases or decreases, what happens to stock price?

Required return increases → Stock price decreases. Required return decreases → Stock price increases.

If dividends or dividend growth increase, what happens to stock price?

Stock price increases, holding other factors constant and assuming the model remains valid.

Why must dividend growth be less than required return?

Otherwise the constant-growth formula cannot produce a finite positive stock price.

What is dividend yield?

The return from dividends. Formula: D1 / P0.

What is capital gains yield?

The return from an increase in stock price. Under constant growth, it equals the dividend growth rate.

What is total stock return?

Dividend Yield + Capital Gains Yield. Under constant growth, Required Return = D1/P0 + g.

What is nonconstant dividend growth?

When dividends grow at different rates before eventually becoming constant.

How do you value a nonconstant-growth stock?

Calculate each dividend, find the horizon value when constant growth begins, and discount everything back to today.

What is horizon value?

The value of future dividends at the point constant growth begins. Formula: Pt = D(t+1) / (rs - g).

How does free cash flow valuation work?

Find the present value of future FCFs using WACC. Higher expected FCF generally increases value, while higher WACC decreases value.

What is WACC?

Weighted Average Cost of Capital; the average cost of financing a company using debt and equity.

Why is WACC important?

It is the minimum return a typical-risk project must earn to cover its financing cost.

What is the WACC formula?

WACC = wd × rd × (1-T) + wps × rps + ws × rs.

What are the three financing sources used in WACC?

Debt, preferred stock, and common equity.

What is the cost of debt?

The return lenders require, usually found using a bond's YTM.

What is the after-tax cost of debt?

Cost of Debt × (1 - Tax Rate). It is lower because interest is tax-deductible.

If the tax rate increases, what happens to after-tax cost of debt?

It decreases, holding before-tax debt cost constant.

What is the cost of preferred stock?

Preferred Dividend / Preferred Stock Price. Preferred dividends are not tax-deductible.

What is the cost of common equity?

The return common shareholders require for investing in a company.

What are the three methods of finding cost of equity?

CAPM, dividend growth model, and bond-yield-plus-risk-premium.

What are capital structure weights?

The percentage of financing from each source. All weights must add up to 100%.

What is the difference between book, market, and target weights?

Book = accounting values. Market = current market values. Target = future financing proportions.

How do you find market values for WACC?

Stock value = Price × Shares. Bond value = Bond Price × Bonds Outstanding. Divide each by total financing market value.

What are flotation costs, and what happens when they increase?

Fees for issuing new securities. Higher flotation costs increase the effective cost of new financing.

How are flotation costs handled?

For new equity, divide the price by (1-F) in the cost formula. For debt, Dr. Fuller's slides use a de minimis test: above the threshold use constant yield; below it use allocation.

What is capital budgeting?

Deciding whether a company should invest in long-term projects.

What is the difference between independent and mutually exclusive projects?

Independent projects can both be accepted. Mutually exclusive projects require choosing between alternatives.

What is payback period?

The time needed to recover the original investment. It ignores time value of money and later cash flows.

What is discounted payback?

The time needed to recover an investment using discounted cash flows. It accounts for time value of money.

What is profitability index (PI)?

The present value of future cash inflows divided by initial investment. PI > 1: Accept. PI < 1: Reject.

What is NPV?

Net Present Value; the present value of cash inflows minus the present value of costs. It measures dollars of value created.

What are the NPV decision rules?

NPV > 0: Accept. NPV < 0: Reject. NPV = 0: The project earns exactly its required return.

If WACC increases, what happens to NPV?

NPV decreases for a normal project with positive future cash inflows.

What is IRR?

Internal Rate of Return; the discount rate that makes NPV equal zero.

What are the IRR decision rules?

IRR > WACC: Accept a normal independent project. IRR < WACC: Reject. IRR = WACC: NPV is zero.

What is the difference between NPV and IRR?

NPV measures dollars of value created. IRR measures percentage return. NPV is preferred for maximizing shareholder wealth.

How should companies choose between projects?

Independent projects: Accept all with positive NPV if funding permits. Mutually exclusive projects: Choose the highest positive NPV.

Why can NPV and IRR disagree?

Differences in project size or cash flow timing can cause conflicting rankings. The crossover rate is where two projects have equal NPVs.

What is MIRR, and why is it useful?

Modified IRR assumes reinvestment at WACC rather than IRR and helps avoid multiple-IRR problems from nonnormal cash flows.

How do companies compare projects with unequal lives?

Use the replacement chain method or equivalent annual annuity (EAA) when projects can be repeated.