finance

• Systematic risk


  Risk that affects the entire market or economy, not just a particular stock or industry
• 1. Bill


  Treasury Bills, risk-free assets
• Beta (β)


  Measure of a security's sensitivity to movements in the overall market
• If β > 1

  Securities react more than proportionately to market movements (high systematic risk)
• If β < 1

  Securities react less than proportionately to market movements (low systematic risk)
• Expected market return


  The return that investors expect to earn on the market portfolio
• If β > 1

  Higher systematic risk, higher required return
• If β < 1

  Lower systematic risk, lower required return
• CAPM (Capital Asset Pricing Model)


  Formula to calculate the required return for a security based on its risk
• Risk premium


  The additional return investors require for holding a risky asset instead of a risk-free asset
• Relationship between asset return and risk

  Linear and called the security market line
• Portfolio Beta (Bp)


  Weighted average of the betas of the individual assets in the portfolio
• Diversification reduces unsystematic risk
• Stocks are riskier than bonds
• NPV, PI, IRR


  Capital budgeting decision rules
• Working capital (NWC)


  Short-term assets minus short-term liabilities, needed for day-to-day operations
• We accept the project if PI > 1
• Relevant cash flows


  Include incremental cash inflows and outflows directly attributable to the project, never accounting items like interest, principal repayment, or dividends
• Always consider additional investment at the end of the project's life, never sunk costs already paid
• Corporate taxation


  Capital gains tax payable when assets are sold, always after-tax cash flows
• Steps to calculate depreciation

  1. Determine purchase price

  2. Determine useful life

  3. Calculate annual depreciation
• Depreciation is tax-deductible, so it reduces taxable income
• Discounted Payback rule


  Accept if time until discounted cash flows equal initial investment is less than a pre-specified number of years
• Average Accounting Return (AAR)


  Acceptable if higher than a target AAR
• Internal Rate of Return (IRR)

  Acceptable if higher than the required rate of return
• IRR is more popular than NPV because it's easier to understand
• Capital Rationing


  Situation where a firm has limited capital available for investment
• Stand-Alone analysis


  Focuses on the incremental cash flows resulting from undertaking the proposed project
• Erosion


  Negative impact on cash flows due to loss of value of financial assets
• Business taxes in Canada

  • Grants
  • Investment tax credits
  • Capital cost allowance (CCA)
  • Subsidized loans
• Equivalent Annual Cost (EAC)


  The amount paid each year over the life of a machine that has the same present value as the actual cash flows
• Changes in interest rates

  Move in the same direction as the value of bonds
• Capital Budgeting Decisions


  Decisions about which long-term investment projects to undertake
• Financing Decisions


  • Issuing debt
  • Issuing equity
  • Repurchasing shares
• Dividend Decisions


  Decisions about how much of the firm's earnings to pay out as dividends
• WACC (Weighted Average Cost of Capital)

  The overall return that the firm must earn on its existing assets to maintain the value of its stock
• Steps to calculate WACC

  1. Calculate weights of each funding source

  2. Calculate cost of each funding source

  3. Calculate WACC
• Optimal Capital Structure


  The best ratio of debt to equity that maximizes the value of the firm
• Increasing leverage


  Increases ROE but also increases risk to shareholders
• Cost of Equity (Re)


  The required rate of return demanded by shareholders