Chapter 1: Corporate Finance and the Financial Manager (стр. 4 )

8. Why would excessive trading lead to lower realized returns?

If a trader has no above average ability but trades excessively, the trader will experience high costs of trading due to commissions and bid-ask spreads. These high trading costs will lead to lower returns.

Chapter 11: Risk and Return in Capital Markets

1. Historically, which types of investments have had the highest average returns and which have been the most volatile from year to year? Is there a relation?

On average, stocks have had higher returns than bonds, with small company stocks having higher returns than large company stocks. Stocks have also had more volatile returns, with small company stock returns being the most volatile. There is a relationship that the investments with the greatest (least) amount of volatility have the greatest (least) average return.

2. Why do investors demand a higher return when investing in riskier securities?

Investors do not like risk. If two securities have the same expected return and different levels of risk, investors will choose the security with the lower level of risk. The only way to entice investors to purchase the more risky security is for it to have a higher expected return.

3. For what purpose do we use the average and standard deviation of historical stock returns?

The average and the standard deviation describe the distribution of returns for a normal distribution. The average tells us what the return tends to be, and the standard deviation tells us how far away
from the average the return in any particular year is likely to be.

4. How does the standard deviation of historical returns affect our prediction in predicting the next period’s return?

The larger the standard deviation, the farther away from the average the next period’s return might be. About 95% of the time, the return will be within ±2 standard deviations of the average.

5. What is the relation between risk and return for large portfolios? How are individual stocks different?

There is a positive relation between risk (as measured by standard deviation) and average return for large portfolios of assets. There is no clear relationship between volatility and returns for individual stocks.

6. Do portfolios or the stocks in the portfolios tend to have the lower volatility?

Portfolios tend to have lower volatility than the individual stocks in the portfolio have.

7. What is the difference between common and independent risk?

Common risk is the risk that is perfectly correlated across investments. This risk affects all risky assets and cannot be eliminated through diversification. Independent risk is uncorrelated across investments and can be eliminated in a diversified portfolio.

8. How does diversification help with independent risk?

Because independent risk is uncorrelated across investments, when one investment is impacted negatively by an event, other investments are not impacted. Therefore, only one investment in the portfolio decreases in value.

9. Why is the risk of a portfolio usually less than the average risk of the stocks in the portfolio?

By holding a number of stocks in a portfolio, the investor is diversifying away unsystematic risk.

10. Does systematic or unsystematic risk require a risk premium? Why?

Only systematic risk requires a risk premium. Investors can eliminate unsystematic risk through diversification; therefore, they receive no return premium for unsystematic risk.

Chapter 12: Systematic Risk and the Equity Risk Premium

1. What do the weights in a portfolio tell us?

Portfolio weights tell us the fraction of the total investment in the portfolio held in each individual security.

2. How is the expected return of a portfolio related to the expected returns of the stocks in the portfolio?

The expected return of a portfolio is the weighted average of the expected returns of the individual stocks in the portfolio.

3. What determines how much risk will be eliminated by combining stocks in a portfolio?

The amount of risk that will be eliminated by combining stocks in a portfolio depends on the correlation between the two stocks. The higher the correlation between the two stocks, the more the two stocks move together, and the less the risk will be lowered by combining the two stocks.

4. When do stocks have more or less correlation?

Stocks that are in the same industry and stocks that are impacted by the same economic conditions are more correlated. For example, two airline companies would be more correlated than an airline company and a pharmaceutical company would be.

5. What is the market portfolio?

The market portfolio is the portfolio of all risky investments, held in proportion to their market capitalization.

6. What does beta (b ) tell us?

Beta measures the sensitivity of an investment to the fluctuations of the market portfolio. Beta tells us how much an investment’s excess return is expected to change for each 1% change in the market portfolio’s excess return.

7. What does the CAPM say about the required return of a security?

The CAPM model says that the required return of a security equals the risk-free rate plus a percentage of the market risk premium, where the percentage of the market risk premium is based on beta, or the security’s systematic risk.

8. What is the Security Market Line?

The Security Market Line (SML) is the line that goes through the risk-free investment (with a beta of 0) and the market (with a beta of 1). It shows the linear relation between the expected return and systematic risk, as measured by beta.

Chapter 13: The Cost of Capital

1. Why does a firm’s capital have a cost?

To attract potential investors, the firm must offer them an expected return equal to what they could expect to earn elsewhere for assuming the same level of risk. This return is the cost a company bears to obtain capital from its investors.

2. Why do we use market value weights in the weighted average cost of capital?

Market value weights are used because equity and debt holders assess the firm based on the market value of its assets rather than the book value of its assets.

3. How can you measure a firm’s cost of debt?

A firm’s cost of debt can be measured by the yield to maturity on the firm’s existing debt because it is the return that current purchasers of the debt would earn if they held the debt to maturity.

4. What are the major tradeoffs of using the CAPM versus the CDGM to estimate the cost of equity?

To use the CAPM, we need to know the equity beta, the risk-free rate, and the market risk premium; we must assume that the estimated beta and market risk premium are accurate and the CAPM is a correct model. The CDGM requires that we know the current stock price, the expected dividend for next year, and the future dividend growth rate. CDGM can only be used if we assume that the future dividend growth rate is constant.

5. Why do different companies have different WACCs?

The WACC of companies will differ depending on the risk of the line of business of the companies and the amount of leverage the companies have.

6. What are the tradeoffs in estimating the market risk premium?

To estimate the market risk premium, we rely on historical data. It takes many years of historical data to estimate reliably the market risk premium. However, older data may have little relevance to how investors view market risk today.

7. What are the main assumptions you make when you use the WACC method?

The main underlying assumptions of the WACC method are that the market risk of the project is equivalent to the average market risk of the firm’s investments, the firm’s debt-equity ratio remains constant, and the main effect of leverage on valuation follows from the interest tax deduction.

8. What inputs do you need to be ready to apply the WACC method?

To apply the WACC method, you need to determine the incremental free cash flow of the investment and the weighted average cost of capital. You use this information to compute the value of the investment, including the tax benefit of leverage, by discounting the incremental free cash flow of
the investment using the WACC.

9. When evaluating a project in a new line of business, which assumptions about the WACC method are most likely to be violated?

Specific projects often differ from the average investment made by the firm, violating the assumption that the project’s risk is equivalent to the average risk of the firm’s investments. Projects may also vary in terms of the amount of leverage they will support and the assumption that the debt-equity ratio will remain constant does not hold.

10. How can you estimate the WACC to be used in a new line of business?

You can estimate the WACC to be used in a new line of business by benchmarking off of companies that compete in the new line of business and are focused in that single line of business.

11. What types of additional costs does a firm incur when accessing external capital?

Costs of issuing external capital include Securities & Exchange Commission filing and registration fees and fees paid to investment bankers.

12. What is the best way to incorporate these additional costs into capital budgeting?

The best way to incorporate these additional costs is to consider the issuing costs as cash outflows and incorporate the costs as negative cash flows in the NPV process.

Chapter 14: Raising Equity Capital

1. What are the main sources of funding for private companies to raise outside equity capital?

Private companies can raise outside equity capital from angel investors, venture capital firms, institutional investors, and corporate investors.

2. What is a venture capital firm?

A venture capital firm is a limited partnership that specializes in raising money to invest in the private equity of young firms.

3. What services does the underwriter provide in a traditional IPO?

An underwriter is an investment banking firm that manages the offering and designs its structure. The underwriter markets the IPO, helps the company with all the necessary filings, and actively participates in determining the offer price. Often the underwriter will also commit to making a market in the stock by matching buyers and sellers after this issue to guarantee liquidity.