Investments, Risks and Rate of Return

• 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