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25 Cards in this Set
- Front
- Back
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Cost of Capital (Cost of equity formula or Gordon growth model) |
(Dividend per share for next year / current market value) + constant growth of dividends |
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Differences between CAPM and Gordon growth model |
a. The CAPM directly considers risk because it usesbeta b. The constant growth model does not look at risk;it uses the market price as a reflection of the expected risk-return preferenceof investors in the marketplace |
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What is the cost of Common Stock? |
a. The rate at which investors discount theexpected dividends of the firm to determine its share value b. Returnrequired on the stock by investors in the marketplace (CAPM) |
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Weighted Average Cost of Capital |
Reflects the expected average future cost ofcapital over the long run’ found by weighting the cost of each specific type ofcapital by its proportion I the firm’s capital structure. |
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Weighted Average Cost of Capital Formula |
WACC = (weight xcost of 1) x (weight x cost 2) x (weight x cost 3) |
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If is says, most recent dividend, then that dividend occurred in year? |
Zero. You need to find next years dividend by growing it. |
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Present Value Formula |
PRESENT VALUE = FV / ( 1 + r) ^n |
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Future Value Formula |
PV ( 1 + r) ^n |
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Stock Valuation (no growth) |
Value of stock = Dividend / required return |
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Stock Valuation (constant growth) |
Value of stock = Dividend in year 1 / (required rate of return – CONSTANT GROWTH) |
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Stock Valuation (uneven growth) |
Look at handout |
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Market Efficiency |
a. Stock prices fluctuate and will move towards anew equilibrium that reflects the most recent information available. b. Market efficiency assumes that the quickreactions of rational investors to new information cause the market value ofcommon stock to adjust upward or downward quickly. i. Assumes that: (1) securities are in equilibrium(2) security prices fully reflect all available information and react swiftlyto new information, and (3) because stock are fully and fairly priced,investors need not waste time looking for mis-priced securities ii. Expected return and required return should beequal in an efficient market iii. Assumption: a stock’s market price is at anypoint in time the best estimate of its value.0*1 |
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Value of Common Stock |
a. Holders are rewarded through periodic cashdividends and an increasing share valueb. THE VALUE OF A SHARE OF COMMON STOCK IS EQUAL TOTHE PRESENT VALUE OF ALL FUTURE CASH FLOWS (DIVIDENTDS) THAT IT IS EXPECTED TOPROVIDE. THE BUYER PAYS FOR THE RIGHTS TO ALL FUTURE DIVIDENDS
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Free Cash Flow Model |
A model that determines the value of an entirecompany as the present value of its expected free cash flows discounted at thefirms weighted average cost of capital, which is expected average future costof funds over the long run. |
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The relationshipamong financial decisions, return, risk, and the firm’s value |
Any action of the financial manager thatincreases the level of expected dividends without changing risk should increaseshare value. Any action that increases risk (required return) will reduce sharevalue. |
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Differences between debt and equity |
a. Debt financing is obtain from creditors andequity financing is obtained by investors who become owners in the firmb. Creditors have a legal right to be repaid,investors only have an expectation of being repaidc. Equity- funds provided by the firms ownersd. Debt is prepaid through a fixed schedule ofpaymentse. Equity is repaid subject to the firm’sperformance f. Investors claim on income or assets is secondaryto creditors, therefore they expect greater returnsnatur* |
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Risk |
A measure of uncertainty surrounding the returnthat an investment will earn, or, more formally, the variability of returnsassociated with a given asset. A firm’s risk and expected return directly affect its shareprice. Risk and return are the two key determinants of the firm’s value. It istherefore the financial manager’s responsibility to assess carefully the riskand return of all major decisions to ensure that the expected return justifythe level of risk being introduced. The financial manager can expect to achievethe firm’s goal of increasing its share price (and thereby benefitting itsowners) by taking only those actions that earn returns at least commensuratewith their risk.443":) |
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Standard Deviation |
The most common statistical indicator of anasset’s risk; it measures the dispersion around the expected values.b. The portfolio standard deviation is found byusing the formula for for standard deviation of a single asset. |
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Expected Value of a return (r-bar) s |
a. The average return that an investment isexpected to produce over time.b. For example, if an asset is given threescenarios (pessimistic, most likely, optimistic), the expected return is thesum of the weighted values of the return. |
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Total rate of return |
a. The total gain or loss experienced on aninvestment over a given period of time’ calculated by dividing the assets cashdistributions during the period, plus the change I its value, by itsbeginning-of-period investment value. |
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Coefficient of variation |
a. A measure of relative dispersion that is usefulin comparing the risks of assets with differing expected returns. b. A higher coefficient of variation means that aninvestor has more volatility relative to its expected return. |
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Scenario analysis |
a. An approach for assessing risk that uses severalpossible alternative outcome (scenarios) t obtain a sense of the variabilityamong return. |
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Risk and Diversification |
a. Combining assets that have the lowest possiblecorrelationb. Combine negatively correlated assets!c. You want assets that are negatively correlated.Whenever assets are perfectly negatively correlated, some combination of thetwo assets exists such that the resulting portfolio’s return are risk free. d. Un-diversifiable risk = war, inflation, overallstate of economy, international incidents….+* |
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Capital Asset Pricing Model |
a. Links undiversifiable risk to expected returnsb. Measures systematic risk (risk that cannot bediversified away)c. Finds the “required return”d. The first part of the formulas, RF, representthe time value of moneye. The second part determines how much additionalrisk an investor should take on based upon the additional risk. f. Everything is in relation to the marketg. Equals cost of equity i. Problems with CAPM1. Relies on historical data2. Betas may or may not reflect the futurevariability of returns3. Based on an assumed ‘efficient market’ /¨C |
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Beta |
a. Measures volatility in relation to the market;or,b. Ameasure of un-diversifiable risk c. The higher the beta, the riskier the stock, andthe more return you should received. You can find portfolio betas ( or betas of acombination of anything, really) by multiplying the weights by the betas |
