Business Finance Exam 3 (Chapters 11, 12, and 13)

A dividend payment or capital gain/capital loss

2 types of return on stocks and bonds

Percentage return on investment

(Capital gain+ Dividend)/Initial share price

Dividend yield

dividend/initial share price

Percentage Capital Gain

Capital gain/initial share price

Market Index

Measure of the investment performance of the overall market.

Dow Jones Industrial Average

Index of the investment performance of a portfolio of 30 “blue-chip” stocks.

Standard and Poor’s Composite Index (S&P 500)

Index of the investment performance of a portfolio of 500 large stocks. Also called the S&P 500.

Treasury bills, Treasury Bonds, and Common Stock

From safest to riskiest rank 3 securities: Treasury bills, Treasury bonds, and Common Stock.

Maturity Premium

Extra annual return from investing in long- versus short-term Treasury securities.

Risk Premium

Expected return in excess of risk-free return as compensation for risk.

Rate of return on CS= interest rate on treasury bills + market risk premium

What is the rate of return on Common Stock?

Variance

Average value of squared deviations from mean. A measure of volatility.

Standard Deviation

Square root of variance. A measure of volatility.

Diversification

Strategy designed to reduce risk by spreading the portfolio across many investments. It works best with negatively correlated investments.

Investment Opportunity Frontier

Plot of the combinations of expected return versus standard deviation for various portfolio weights.

Specific/Diversifiable/Unique/Residual Risks

Risk factors affecting only that firm.

Market/Systematic risks

Economywide (macroeconomic) sources of risk that affect the overall stock market.

3 messages about risk

1.Some risks that appear to be big and scary are diversifiable. 2. Market risks are macro risks 3. Risk can be measured.

Market portfolio

Portfolio of all assets in the economy. In practice a broad stock market index is used to represent the market.

Beta

Sensitivity of a stock’s return to the return on the market portfolio.

Defensive stocks

Not very sensitive to market fluctuations and have low betas ( less than 1).

Aggressive stocks

Sensitive to market fluctuations and have betas greater than 1.

Fraction of portfolio in stock 1*Beta of stock 1 + fraction of portfolio in stock 2*Beta of stock 2.

Portfolio beta calculation

Market risk premium

Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills.

CAPM (Capital Asset Pricing Model)

Theory of the relationship between risk and return that states that the expected risk premium on any security equals its beta times the market risk premium. Calculated as =r_f+β(r_m-r_f).

Security Market Line

Relationship between expected return and beta. Describes the expected returns and risks from splitting your overall portfolio between risk-free securities and the market.

Project cost of capital

Minimum acceptable expected rate of return on a project given its risk.

Company cost of capital

Opportunity cost of capital for investment in the firm as a whole. The company cost of capital is the appropriate discount rate for an average-risk investment project undertaken by the firm assuming all-equity finance.

Capital Structure

The mix of long-term debt and equity financing.

Market Weights

The cost of capital must be based on what investors are actually willing to pay for the company’s outstanding securities—that is, based on the securities’ market values.

Weighted-average cost of capital (WACC)

Expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments. WACC is the correct discount rate for projects that have similar risks to the company’s existing business. Calculated as [(D/V)*(1-T)r_debt]+(P/V)*r_preferred+(E/V)*r_equity.

Dividend Discount Model

P₀=(DIV₁)/(r_equity-g)

Price of preferred stock

Dividend/r_preferred

Free Cash Flow (FCF)

Cash flow available for distribution to investors after firm pays for new investments or additions to working capital.