Investments, Risks and Rate of Return

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Created by
claire

Cards (20)

  • Business Risk - the risk a firm's common shareholders would face if the firm had no debt
  • Financial risk - the additional risk placed on the common shareholders as a result of the decision to finance with debt
  • Measures of risk:
    1. Standard deviation
    2. Coefficient of variation
  • Leverage - refers to that protion of the fixed costs which represents a risk to the firm
    1. Operating (DOL) = CM/Earnings before interest and taxes
    2. Financial (DFL) = Earnings before interest and taxes/(EBIT - Int Exp-Preferred Dividend)
  • S1: The higher the operating leverage, the higher the business risk and lower its optimal debt ratio
    S2: The higher the financial leverage, the higher the financial risk and the higher the cost of capital
    Both statements are correct
  • Degree of Total Leverage = DOL x DFL
  • Other types of risk:
    1. Market
    2. Liquidity
    3. Political
    4. Exchange rate
    5. Security
    6. Company
    7. Interest rate
  • Derivatives, including options and futures, are contracts between the parties who contract. Unlike stocks and bonds, they are not claims on business assets.
  • Forward contract - involves a commitment today to purchase a product on a specific date at a price determined today
  • Future contract - has mark-to-market provision
    1. Speculation
    2. Hedging
  • CAPM = Risk free rate + (Beta coefficient x (Market return - Risk free rate))
  • Beta coefficient of an individual stock is the correlation between volatility (price variation) of the stock market and the volatility of the price of the individual stock
  • The mix of debt , PS, and common equity with which the firm plans to raise capital is called the target capital structure
  • The mix of debt and equity that minimizes the cost of capital is the optimal capital structure
  • The discount rate that makes the PV of a bond's payments equal to its prices is termed the yield to maturity
  • The overall cost of long-term financing for the firm is called the WACC
  • The cost of capital at the RE breakpoint is the marginal cost of capital
  • If an individual stock's beta is higher than 1.0, the stock is riskier than the market
  • The market risk premium is the difference between the rate of return on the market portfolio and the risk free rate
  • Capital asset pricing model (CAPM) is a method that explicitly recognizes a firm's risk when determining the estimated cost of capital