cost of capital, market efficiency + behavioural finance

company cost of capital

discount rate for investments with same risk as companies overall business

• used as benchmark for new investments

weighted average cost of capital

average return demanded by investors in companies debt and equity

what two things make the value of the firm

market values of debt + equity

how to find cost of debt and equity in WACC

• cost of debt = YTM on bonds

• cost of equity = CAPM

capital structure

mix of debt and equity within a company

which is less cost of debt or cost of equity

cost of debt < cost of equity

asset beta equation

same as WACC but replace r with beta

asset beta equation

certainty equivalents

• C/1+r, risk adjusted r

• certain cash/1+r = ^, risk free r

  • use to find certain cash flow

intrinsic value

fundamental economic worth of an asset

fair price

market price as an unbiased estimate of intrinsic value

efficient market hypothesis

• prices are unbiased and random so trading shouldn’t result in abnormal profits

• cycles self-destruct as they are recognised by investors

efficient market theory, 3 forms of efficiencies with summary

weak form efficiency

• market prices reflect historical information and prices follow random walks

semistrong form efficiency

• market prices reflect all publicly available information

• prices react immedicable to public information

strong form efficiency

• marker prices reflect all information, public and private

weak form efficiency

• movement of stock prices is random but positive skew over long term

• price changes are independent of one another

• only new information determines tomorrows price

• no profit from technical analysis

how to calculate abnormal return in semistrong efficiency

• adjusted stock return = return on stock - return on market index

• abnormal stock return = actual stock return - expected stock return (CAPM)

strong form efficiency

• cannot pick winning stocks so must use diversification or indexing

what is a bubble

prices go to extreme then crash

• hard to detect as it could be rational or a bubble

• form because investors imitate each other

4 concepts of behavioural finance

• attitudes toward risk

  • loss aversion

• beliefs about probabilities

  • systematic errors in assessing probability of uncertain events such as recency bias, too conservative or overconfidence

• sentiment

• limits to arbitrage

  • mispriced securities will return to fundamental values

6 lessons of market efficiency

1. markets have no memory

2. trust market prices

3. read the entrails

4. there are no financial illusions

5. do it yourself alternative

6. seen one stock seen them all

markets have no memory

past price movements don’t reflect future prices movements

trust market prices

in efficient market prices reflect all available information so current prices are best available estimate of true value

read the entrail

prices contain useful information about the future because it incorporates PV of future cash flows

there are no financial illusions

rearranging financial statements creates no real value as that depends only on cash flows

do it yourself alternative

investors will not pay for something they can do themselves

• if two companies merge to reduce risk it won’t affect investor who can diversify their own portfolio at a lower cost

seen one stock seen them all

no stock is better than others once risk is considered