FINMAN PRE-FI

• Investment Returns and Risk


  With most investments, an individual or business spends money today, expecting to earn even more in the future. However, most investments are risky.
• Return on Investments


  The concept of return provides investors with a convenient way to express the financial performance of an investment.
• To make a meaningful judgment about the return

  • The scale (size) of the investment must be known
  • The timing of the return must be known
• Solution for scale and timing problems

  Express investment results as rates of return, or percentage returns
• Risk


  A probability or threat of damage, injury, liability, loss, or any other negative occurrence caused by external or internal vulnerabilities that may be avoided through preemptive action
• Analyzing an asset's risk

  • On a stand-alone basis, where the asset is considered in isolation
  • As part of a portfolio, which is a collection of assets
• Probability Distributions


  A listing of possible outcomes or events with a probability assigned to each outcome
• Expected Rates of Return, 𝑟̂ ("r hat")

  The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results
• Standard Deviation, 𝜎 (sigma)


  A statistical measure of the variability of a set of observations
• Standard Deviation, ��


  • Useful to measure risk for comparative purposes
  • The smaller the standard deviation, the tighter the probability distribution, and the lower the risks
  • Measures how far the actual return is likely to deviate from the expected return
• Historical, or Past Realized, Rates of Return, 𝑟 ("r bar")


  The mean and standard deviation can be computed based on a subjective probability distribution
• Coefficient of Variation (CV)


  The risk per unit of return, providing a more meaningful risk measure when the expected returns on two alternatives are not the same
• Sharpe Ratio


  Compares the asset's realized excess return to its standard deviation over a specified period
• Risk-averse investors


  Dislike risk and require higher rates of return as an inducement to buy riskier securities
• Risk Premium (RP)


  The difference between the expected rate of return on a given risky asset and that on a less risky asset
• The risk of a stock in a "portfolio" is typically lower than its risk when it is held alone
• Expected return on a portfolio (𝒓̂𝒑

  )

  The weighted average of the expected returns of the individual assets in the portfolio, with the weights being the percentage of the total portfolio invested in each asset
• Beta Coefficient


  Measures the relevant risk that remains once the stock is in a diversified portfolio and contributes to the portfolio's market risk
• Relevant Risk


  The risk that remains once the stock is in a diversified portfolio and contributes to the portfolio's market risk. It is measured by the extent to which the stock moves up or down with the market.
• Diversified Risk


  The part of a security's risk associated with random events; it can be eliminated by proper diversification. This risk is also known as company-specific or unsystematic risk.
• Market Risk


  The risk that remains in a portfolio after diversification has eliminated all company-specific risk. This risk is also known as nondiversifiable or systematic, or beta risk.
• The tendency of a stock to move with the market is measured by its beta coefficient, b. Analysts often use historical data and assume that the stock's historical beta will give them a reasonable estimate of how the stock will move relative to the market in the future.
• Market value of equity


  Share price of common stock multiplied by the number of shares outstanding
• Market value of debt


  Assumes the company's debt is trading at par, so the market value of debt equals the book value of debt
• Target Capital Structure


  The mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects
• Market value of equity


  Number of shares of stock outstanding multiplied by the current stock price
• Capital components


  • Debt
  • Preferred stock
  • Common equity
• Increases in capital components must finance increases in assets
• Weighted Average Cost of Capital (WACC)


  The weighted average of debt, preferred stock, and common equity component costs
• Before-tax component cost of debt


  The interest rate on the firm's new debt
• After-tax component cost of debt


  The interest is tax-deductible, so the after-tax cost of debt is lower than its before-tax cost
• Cost of Debt


  The interest rates a firm must pay on its new debt
• The after-tax cost of debt was used in calculating the WACC because the target is to maximize the value of the firm's stock
• Cost of preferred stock


  The rate of return investors require on the firm's preferred stock
• Cost of retained earnings


  The rate of return required by stockholders on a firm's common stock
• Cost of retained earnings, 𝑟𝑠

  The rate of return required by stockholders on a firm's common stock
• Retained earnings should be "free" because they represent "leftover" money after dividends are paid
• Weighted average cost of capital (WACC)

  Calculates a firm's cost of capital from all sources, including common and preferred stock, bonds, and other forms of debt
• If interest rates in the economy rise

  The cost of debt increases because the firm must pay bondholders more when it borrows
• If stock prices decline, pulling the firm's stock price down

  Its cost of equity will rise