The Tangent or Efficient Portfolio


 Cathleen Briggs
 2 years ago
 Views:
Transcription
1 The Tangent or Efficient Portfolio 1
2 2 Identifying the Tangent Portfolio Sharpe Ratio: Measures the ratio of rewardtovolatility provided by a portfolio Sharpe Ratio Portfolio Excess Return E[ RP ] r = = Portfolio Volatility SD( R ) P f The portfolio with the highest Sharpe ratio is the portfolio where the line with the riskfree investment is tangent to the efficient frontier of risky investments. The portfolio that generates this tangent line is known as the tangent portfolio.
3 3 Identifying the Tangent Portfolio Combinations of the riskfree asset and the tangent portfolio provide the best risk and return tradeoff available to an investor. This means that the tangent portfolio is efficient and that all efficient portfolios are combinations of the riskfree investment and the tangent portfolio. Every investor should invest in the tangent portfolio independent of his or her taste for risk. An investor s preferences will determine only how much to invest in the tangent portfolio versus the riskfree investment. Conservative investors will invest a small amount in the tangent portfolio. Aggressive investors will invest more in the tangent portfolio. Both types of investors will choose to hold the same portfolio of risky assets, the tangent portfolio, which is the efficient portfolio.
4 4 LECTURE 06 Cost of Capital Berk, De Marzo Chapter 12 and 13
5 5 The Capital Asset Pricing Model The Capital Asset Pricing Model (CAPM) allows us to identify the efficient portfolio of risky assets without having any knowledge of the expected return of each security. Instead, the CAPM uses the optimal choices investors make to identify the efficient portfolio as the market portfolio, the portfolio of all stocks and securities in the market. Investors hold only efficient portfolios of traded securities portfolios that yield the maximum expected return for a given level of volatility. Investors have homogeneous expectations regarding the volatilities, correlations, and expected returns of securities. Homogeneous Expectations All investors have the same estimates concerning future investments and returns.
6 6 Assumption CAPM NO transcation costs and No personal income taxes All investor have the same level of information Investor s trade securities at competitive market price Investor choose the efficcient portfolios Investors have the homogenous expectations reagarding the volatilities correlations and expected return of a securities Unlimited short sale allowed Unlimited lending and borrowing allowed at riskless rate.
7 7 CAPM In equilibrium, every asset must be priced so that its riskadjusted required rate of return falls exactly on the security market line. Total Risk = Systematic Risk + Unsystematic Risk. Systematic Risk a measure of how the asset covaries with the entire economy (e.g., interest rate, business cycle). Unsystematic Risk idiosyncratic shocks specific to asset i, (e.g., loss of key contract, death of CEO). CAPM quantifies the systematic risk of any asset as its beta Beta measures the sensitivity of a security to marketwide risk factors Expected return of any risky asset depends linearly on its exposure to the market (systematic) risk, measured by beta.
8 8 Beta We can use the beta of the investment to determine the scale of the investment in the market portfolio that has equivalent systematic risk. The Capital Asset Pricing Model (CAPM) is a practical way to estimate. The cost of capital of any investment opportunity equals the expected return of available investments with the same beta. The estimate is provided by the Security Market Line equation: r i =r f +β i (E[R Mkt ]r f ) The equation implies there is a linear relationship between a stock s beta and its expected return. The line going from the riskfree to the market portfolio is called security market line (SML).
9 9 The Security Market Line The SML shows the expected return for each security as a function of its beta with the market. According to the CAPM, the market portfolio is efficient, so all stocks and portfolios should lie on the SML.
10 10 The Security Market Line Beta of a Portfolio: The beta of a portfolio is the weighted average beta of the securities in the portfolio. β ( xi Ri, RMkt ) Cov( RP, R ) Cov Mkt i Cov( Ri, RMkt ) = = = x = i Var ( R ) Var ( R ) Var ( R ) P i i i i Mkt Mkt Mkt x β
11 11 CAPM Under CAPM assumptions it is the line along which all the securities should lie when plotted according to their expected return and betas. Expected return of a portfolio depends on portfolio s beta. The cost of capital of any investment opportunity equals the expected return of available investments with the same beta. This estimate is provided by the Security. Investors will require a risk premium comparable to what they would earn taking the same market risk through an investment in the market portfolio.
12 12 Application Linear Regression: The statistical technique that identifies the bestfitting line through a set of points. (R i r f ) = α i + β i (R Mkt r f ) + ε i α i is the intercept term of the regression. β i (R Mkt r f ) represents the sensitivity of the stock to market risk. When the market s return increases by 1%, the security s return increases by β i %. ε i is the error term and represents the deviation from the bestfitting line and is zero on average.
13 13 Linear Regression Since E[ε i ] = 0: Using Linear Regression E[ R ] = r + β ( E[ R ] r ) + i f i Mkt f { i Expected return for i from the SML Distance above / below the SML α i represents a riskadjusted performance measure for the historical returns. If α i is positive, the stock has performed better than predicted by the CAPM. If α i is negative, the stock s historical return is below the SML. When the market portfolio is efficient, all stocks are on the security market line and have an alpha of zero. Investors can improve the performance of their portfolios by buying stocks with positive alphas and by selling stocks with negative alphas α
14 14 The Debt Cost of Capital Consider a oneyear bond with YTM of y. For each $1 invested in the bond today, the issuer promises to pay $(1+y) in one year. Suppose the bond will default with probability p, in which case bond holders receive only $(1+yL), where L is the expected loss per $1 of debt in the event of default. So the expected return of the bond is: r d = (1p)y + p(yl) = y pl = Yield to Maturity Prob(default) X Expected Loss Rate The importance of the adjustment depends on the riskiness of the bond.
15 Annual Default Rates by Debt Rating ( ) 15
16 Average Debt Betas by Rating and Maturity 16
17 17 Example Estimating the Debt Cost of Capital In early 2013, auto parts retailer Autozone had outstanding 10year bonds with a yield to maturity of 3% and a BBB rating. If corresponding riskfree rates were 1.5%, and the market risk premium is 8%, estimate the expected return of Autozone s debt, where the expected loss rate is 60%.
18 Example1: Estimating the Debt Cost of Capital Using the average estimates in Table 12.2 and an expected loss rate of 60%, we have: r d = YPL= 3%  0.5%(0.60) = 2.7% Alternatively, we can estimate the bond s expected return using the CAPM and an estimated beta of 0.10 from Table In that case, r d = 1.5% (8%) = 2.3% Both estimates are rough approximations and they both suggest that the expected return of Autozone s debt is below its yieldtomaturity of 3%. 18
19 19 Riskfree Rate In order to determine the appropriate riskfree rate, it is necessary to look at the riskfree assets traded in the financial market. Long term government rate (even on a coupon bond) as the risk free rate on all of the cash flows in a long term analysis. For short term analysis, short term government security rate as the risk free rate. The risk free rate that you use in an analysis should be in the same currency that your cash flows are estimated. The conventional practice of estimating risk free rates is the government bond rate.
20 20 Beta for non Traded Assets In the case of a firm s equity or debt, we estimate the cost of capital based on the historical risk of these securities. Because a new project is not a traded security, this approach is not possible. Instead the most common method for estimating a project s beta is to identify comparable firms in the same line of business as the project. If we can estimate the cost of capital of assets of comparable firms, we can use that estimate as a proxy for the project s cost of capital. The simplest setting is one in which we can find an allequity financed firm in a single line of business that is comparable to the project. Because the firm is all equity, holding the firm s stock is equivalent to owning the portfolio of its underlying assets If the firm has similar market risk of project, we can use comparable firm s equity beta and cost of capital as estimates for the project
21 21 A Project s Cost of Capital Asset (unlevered) cost of capital: Expected return required by investors to hold the firm s underlying assets. Weighted average of the firm s equity and debt costs of capital Asset (unlevered) beta E D r = r + r E+D E+D U E D E D β = β + β E+D E+D U E D
22 22 Financing and the Weighted Average Cost of Capital How might the project s cost of capital change if the firm uses leverage to finance the project? Perfect capital markets In perfect capital markets, choice of financing does not affect cost of capital or project NPV Taxes A Big Imperfection When interest payments on debt are tax deductible, the net cost to the firm is given by: Effective aftertax interest rate = r(1τ C )
23 23 The Weighted Average Cost of Capital Weighted Average Cost of Capital (WACC) E E r = r + r ( 1τ ) wacc E D C E+D E+D Given a target leverage ratio: D r =r  τ r E+D wacc U C D
24 Example:2Cost of Capital 24
25 25 Rational Expectations Ch13 Information and Rational Expectations All investors correctly interpret and use their own information, as well as information that can be inferred from market prices or the trades of others. Regardless of how much information an investor has access to, he can guarantee himself an alpha of zero by holding the market portfolio. Because the average portfolio of all investors is the market portfolio, the average alpha of all investors is zero. If no investor earns a negative alpha, then no investor can earn a positive alpha, and the market portfolio must be efficient.
26 26 Information and Rational Expectations The market portfolio can be inefficient only if a significant number of investors either: Misinterpret information and believe they are earning a positive alpha when they are actually earning a negative alpha, or Care about aspects of their portfolios other than expected return and volatility, and so are willing to hold inefficient portfolios of securities.
27 27 The Behavior of Individual Investors Underdiversification and Portfolio Biases There is much evidence that individual investors fail to diversify their portfolios adequately. Familiarity Bias Investors favor investments in companies they are familiar with Relative Wealth Concerns Investors care more about the performance of their portfolios relative to their peers.
28 28 The Behavior of Individual Investors Excessive Trading and Overconfidence According to the CAPM, investors should hold riskfree assets in combination with the market portfolio of all risky securities. In reality, a tremendous amount of trading occurs each day. Overconfidence Bias Investors believe they can pick winners and losers when, in fact, they cannot; this leads them to trade too much. Sensation Seeking An individual s desire for novel and intense risktaking experiences.
Use the table for the questions 18 and 19 below.
Use the table for the questions 18 and 19 below. The following table summarizes prices of various defaultfree zerocoupon bonds (expressed as a percentage of face value): Maturity (years) 1 3 4 5 Price
More informationSolution: The optimal position for an investor with a coefficient of risk aversion A = 5 in the risky asset is y*:
Problem 1. Consider a risky asset. Suppose the expected rate of return on the risky asset is 15%, the standard deviation of the asset return is 22%, and the riskfree rate is 6%. What is your optimal position
More informationt = 1 2 3 1. Calculate the implied interest rates and graph the term structure of interest rates. t = 1 2 3 X t = 100 100 100 t = 1 2 3
MØA 155 PROBLEM SET: Summarizing Exercise 1. Present Value [3] You are given the following prices P t today for receiving risk free payments t periods from now. t = 1 2 3 P t = 0.95 0.9 0.85 1. Calculate
More informationTPPE17 Corporate Finance 1(5) SOLUTIONS REEXAMS 2014 II + III
TPPE17 Corporate Finance 1(5) SOLUTIONS REEXAMS 2014 II III Instructions 1. Only one problem should be treated on each sheet of paper and only one side of the sheet should be used. 2. The solutions folder
More informationModels of Risk and Return
Models of Risk and Return Aswath Damodaran Aswath Damodaran 1 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for
More informationM.I.T. Spring 1999 Sloan School of Management 15.415. First Half Summary
M.I.T. Spring 1999 Sloan School of Management 15.415 First Half Summary Present Values Basic Idea: We should discount future cash flows. The appropriate discount rate is the opportunity cost of capital.
More informationThis paper is not to be removed from the Examination Halls
~~FN3023 ZA d0 This paper is not to be removed from the Examination Halls UNIVERSITY OF LONDON FN3023 ZA BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences,
More information2. Capital Asset pricing Model
2. Capital Asset pricing Model Dr. Youchang Wu WS 2007 Asset Management Youchang Wu 1 Efficient frontier in the presence of a riskfree asset Asset Management Youchang Wu 2 Capital market line When a riskfree
More informationCHAPTER 9: THE CAPITAL ASSET PRICING MODEL
CHAPTER 9: THE CAPITAL ASSET PRICING MODEL PROBLEM SETS 1. E(r P ) = r f + β P [E(r M ) r f ] 18 = 6 + β P(14 6) β P = 12/8 = 1.5 2. If the security s correlation coefficient with the market portfolio
More informationThe Capital Asset Pricing Model (CAPM)
Prof. Alex Shapiro Lecture Notes 9 The Capital Asset Pricing Model (CAPM) I. Readings and Suggested Practice Problems II. III. IV. Introduction: from Assumptions to Implications The Market Portfolio Assumptions
More informationSAMPLE MIDTERM QUESTIONS
SAMPLE MIDTERM QUESTIONS William L. Silber HOW TO PREPARE FOR THE MID TERM: 1. Study in a group 2. Review the concept questions in the Before and After book 3. When you review the questions listed below,
More informationReview for Exam 2. Instructions: Please read carefully
Review for Exam 2 Instructions: Please read carefully The exam will have 25 multiple choice questions and 5 work problems You are not responsible for any topics that are not covered in the lecture note
More informationRisk (beta), Return & Capital Budgeting Chpt. 12: problems 2,6,9,13,15. I. Applications of CAPM. 1) risk premium
Risk (beta), Return & Capital Budgeting Chpt. 12: problems 2,6,9,13,15 I. Applications of CAPM 1) risk premium estimate from historical data (Ibbotson) 2) risk free rate Tbill vs. Tbond, consistent with
More informationChapter 7 Risk, Return, and the Capital Asset Pricing Model
Chapter 7 Risk, Return, and the Capital Asset Pricing Model MULTIPLE CHOICE 1. Suppose Sarah can borrow and lend at the risk freerate of 3%. Which of the following four risky portfolios should she hold
More informationMBA 8230 Corporation Finance (Part II) Practice Final Exam #2
MBA 8230 Corporation Finance (Part II) Practice Final Exam #2 1. Which of the following input factors, if increased, would result in a decrease in the value of a call option? a. the volatility of the company's
More informationGESTÃO FINANCEIRA II PROBLEM SET 4  SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE
GESTÃO FINANCEIRA II PROBLEM SET 4  SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE 1 ST SEMESTER 20102011 Chapter 12 Estimating the Cost of Capital 121. Suppose
More informationThe CAPM (Capital Asset Pricing Model) NPV Dependent on Discount Rate Schedule
The CAPM (Capital Asset Pricing Model) Massachusetts Institute of Technology CAPM Slide 1 of NPV Dependent on Discount Rate Schedule Discussed NPV and time value of money Choice of discount rate influences
More informationPractice Exam (Solutions)
Practice Exam (Solutions) June 6, 2008 Course: Finance for AEO Length: 2 hours Lecturer: Paul Sengmüller Students are expected to conduct themselves properly during examinations and to obey any instructions
More informationCHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING
CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING Answers to Concepts Review and Critical Thinking Questions 1. No. The cost of capital depends on the risk of the project, not the source of the money.
More informationChapter 17 Does Debt Policy Matter?
Chapter 17 Does Debt Policy Matter? Multiple Choice Questions 1. When a firm has no debt, then such a firm is known as: (I) an unlevered firm (II) a levered firm (III) an allequity firm D) I and III only
More informationChapter 14 Capital Structure in a Perfect Market
Chapter 14 Capital Structure in a Perfect Market 141. Consider a project with free cash flows in one year of $130,000 or $180,000, with each outcome being equally likely. The initial investment required
More informationChapter 7 Portfolio Theory and Other Asset Pricing Models
Chapter 7 Portfolio Theory and Other sset Pricing Models NSWERS TO ENDOFCHPTER QUESTIONS 71 a. portfolio is made up of a group of individual assets held in combination. n asset that would be relatively
More informationCHAPTER 10 RISK AND RETURN: THE CAPITAL ASSET PRICING MODEL (CAPM)
CHAPTER 10 RISK AND RETURN: THE CAPITAL ASSET PRICING MODEL (CAPM) Answers to Concepts Review and Critical Thinking Questions 1. Some of the risk in holding any asset is unique to the asset in question.
More informationThis is the tradeoff between the incremental change in the risk premium and the incremental change in risk.
I. The Capital Asset Pricing Model A. Assumptions and implications 1. Security markets are perfectly competitive. a) Many small investors b) Investors are price takers. Markets are frictionless a) There
More informationMore Tutorial at Corporate Finance
Corporate Finance Question 1. The cost of capital (8 points) St. Claire Enterprises is a levered firm. The equity cost of capital for St. Claire is 7%. The debt cost of capital for St. Claire is 2%. Assume
More informationCHAPTER 10. Capital Markets and the Pricing of Risk. Chapter Synopsis
CHAPE 0 Capital Markets and the Pricing of isk Chapter Synopsis 0. A First Look at isk and eturn Historically there has been a large difference in the returns and variability from investing in different
More informationModule 7 Asset pricing models
1. Overview Module 7 Asset pricing models Prepared by Pamela Peterson Drake, Ph.D., CFA Asset pricing models are different ways of interpreting how investors value investments. Most models are based on
More informationNIKE Case Study Solutions
NIKE Case Study Solutions Professor Corwin This case study includes several problems related to the valuation of Nike. We will work through these problems throughout the course to demonstrate some of the
More informationCapital Asset Pricing Model Homework Problems
Capital Asset Pricing Model Homework Problems Portfolio weights and expected return 1. Consider a portfolio of 300 shares of firm A worth $10/share and 50 shares of firm B worth $40/share. You expect a
More informationValueBased Management
ValueBased Management Lecture 5: Calculating the Cost of Capital Prof. Dr. Gunther Friedl Lehrstuhl für Controlling Technische Universität München Email: gunther.friedl@tum.de Overview 1. Value Maximization
More informationChapter 14: Capital Structure in a Perfect Market
Chapter 14: Capital Structure in a Perfect Market1 Chapter 14: Capital Structure in a Perfect Market I. Overview 1. Capital structure: mix of debt and equity issued by the firm to fund its assets Leverage:
More informationEquity Risk Premiums: Looking backwards and forwards
Equity Risk Premiums: Looking backwards and forwards Aswath Damodaran Aswath Damodaran 1 What is the Equity Risk Premium? Intuitively, the equity risk premium measures what investors demand over and above
More informationReview for Exam 2. Instructions: Please read carefully
Review for Exam Instructions: Please read carefully The exam will have 1 multiple choice questions and 5 work problems. Questions in the multiple choice section will be either concept or calculation questions.
More informationDUKE UNIVERSITY Fuqua School of Business. FINANCE 351  CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2.
DUKE UNIVERSITY Fuqua School of Business FINANCE 351  CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%, and investors pay a tax
More informationThe Capital Asset Pricing Model. Capital Budgeting and Corporate Objectives
The Capital Asset Pricing odel Capital Budgeting and Corporate Objectives Professor Ron Kaniel Simon School of Business University of Rochester 1 Overview Utility and risk aversion» Choosing efficient
More informationCHAPTER 18. Capital Budgeting and Valuation with Leverage. Chapter Synopsis
CHAPTER 18 Capital Budgeting and Valuation with everage Chapter Synopsis 18.1 Overview of Key Concepts There are three discounted cash flow valuation methods: the weighted average cost of capital (WACC)
More informationLeverage. FINANCE 350 Global Financial Management. Professor Alon Brav Fuqua School of Business Duke University. Overview
Leverage FINANCE 35 Global Financial Management Professor Alon Brav Fuqua School of Business Duke University Overview Capital Structure does not matter! Modigliani & Miller propositions Implications for
More informationTHE CAPITAL ASSET PRICING MODEL
THE CAPITAL ASSET PRICING MODEL Szabolcs Sebestyén szabolcs.sebestyen@iscte.pt Master in Finance INVESTMENTS Sebestyén (ISCTEIUL) CAPM Investments 1 / 30 Outline 1 Introduction 2 The Traditional Approach
More information15 Solution 1.4: The dividend growth model says that! DIV1 = $6.00! k = 12.0%! g = 4.0% The expected stock price = P0 = $6 / (12% 4%) = $75.
1 The present value of the exercise price does not change in one hour if the riskfree rate does not change, so the change in call put is the change in the stock price. The change in call put is $4, so
More informationDUKE UNIVERSITY Fuqua School of Business. FINANCE 351  CORPORATE FINANCE Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2.
DUK UNIRSITY Fuqua School of Business FINANC 351  CORPORAT FINANC Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%. Consider a firm that earns $1,000
More informationChapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.)
Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.) The primary focus of the next two chapters will be to examine the debt/equity choice by firms. In particular,
More informationMeanVariance Portfolio Analysis and the Capital Asset Pricing Model
MeanVariance Portfolio Analysis and the Capital Asset Pricing Model 1 Introduction In this handout we develop a model that can be used to determine how a riskaverse investor can choose an optimal asset
More informationExecutive Summary of Finance 430 Professor VissingJørgensen Finance 43062/63/64, Winter 2011
Executive Summary of Finance 430 Professor VissingJørgensen Finance 43062/63/64, Winter 2011 Weekly Topics: 1. Present and Future Values, Annuities and Perpetuities 2. More on NPV 3. Capital Budgeting
More informationCFA Examination PORTFOLIO MANAGEMENT Page 1 of 6
PORTFOLIO MANAGEMENT A. INTRODUCTION RETURN AS A RANDOM VARIABLE E(R) = the return around which the probability distribution is centered: the expected value or mean of the probability distribution of possible
More informationCAPM, Arbitrage, and Linear Factor Models
CAPM, Arbitrage, and Linear Factor Models CAPM, Arbitrage, Linear Factor Models 1/ 41 Introduction We now assume all investors actually choose meanvariance e cient portfolios. By equating these investors
More information1. CFI Holdings is a conglomerate listed on the Zimbabwe Stock Exchange (ZSE) and has three operating divisions as follows:
NATIONAL UNIVERSITY OF SCIENCE AND TECHNOLOGY FACULTY OF COMMERCE DEPARTMENT OF FINANCE BACHELOR OF COMMERCE HONOURS DEGREE IN FINANCE PART II 2 ND SEMESTER FINAL EXAMINATION MAY 2005 CORPORATE FINANCE
More informationCORPORATE FINANCE REVIEW FOR THIRD QUIZ. Aswath Damodaran
CORPORATE FINANCE REVIEW FOR THIRD QUIZ Aswath Damodaran Basic Skills Needed What is the trade off involved in the capital structure choice? Can you estimate the optimal debt ratio for a firm using the
More informationChapter 11. Topics Covered. Chapter 11 Objectives. Risk, Return, and Capital Budgeting
Chapter 11 Risk, Return, and Capital Budgeting Topics Covered Measuring Market Risk Portfolio Betas Risk and Return CAPM and Expected Return Security Market Line CAPM and Stock Valuation Chapter 11 Objectives
More informationThe Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) Tee Kilenthong UTCC c Kilenthong 2016 Tee Kilenthong UTCC The Capital Asset Pricing Model (CAPM) 1 / 36 Main Issues What is an equilibrium implication if all investors
More informationLECTURE 07. Cost of Capital Berk, De Marzo Chapter 14 and 15
1 LECTURE 07 Cost of Capital Berk, De Marzo Chapter 14 and 15 2 Equity Versus Debt Financing Capital Structure: The relative proportions of debt, equity, and other securities that a firm has outstanding.
More informationCIS September 2012 Exam Diet. Examination Paper 2.2: Corporate Finance Equity Valuation and Analysis Fixed Income Valuation and Analysis
CIS September 2012 Exam Diet Examination Paper 2.2: Corporate Finance Equity Valuation and Analysis Fixed Income Valuation and Analysis Corporate Finance (1 13) 1. Assume a firm issues N1 billion in debt
More informationCorporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document)
Corporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document) 1. Portfolio risk & return. Idaho Slopes (IS) and Dakota Steppes (DS) are both seasonal businesses. IS is a downhill
More informationProblem 1 Problem 2 Problem 3
Problem 1 (1) Book Value Debt/Equity Ratio = 2500/2500 = 100% Market Value of Equity = 50 million * $ 80 = $4,000 Market Value of Debt =.80 * 2500 = $2,000 Debt/Equity Ratio in market value terms = 2000/4000
More informationRisk and Return: Estimating Cost of Capital
Lecture: IX 1 Risk and Return: Estimating Cost o Capital The process: Estimate parameters or the riskreturn model. Estimate cost o equity. Estimate cost o capital using capital structure (leverage) inormation.
More informationChapter 5. Conditional CAPM. 5.1 Conditional CAPM: Theory. 5.1.1 Risk According to the CAPM. The CAPM is not a perfect model of expected returns.
Chapter 5 Conditional CAPM 5.1 Conditional CAPM: Theory 5.1.1 Risk According to the CAPM The CAPM is not a perfect model of expected returns. In the 40+ years of its history, many systematic deviations
More informationTopics CHAPTER 9. What types of longterm capital do firms use? Capital Components. Beforetax vs. Aftertax Capital Costs
Topics CHAPTER 9 The Cost of Capital Cost of Capital Components Debt Preferred Common Equity WACC 1 2 What types of longterm capital do firms use? Longterm debt Preferred stock Common equity Capital
More informationThe CAPM & Multifactor Models
The CAPM & Multifactor Models Business Finance 722 Investment Management Professor Karl B. Diether The Ohio State University Fisher College of Business Review and Clarification In the last few lectures
More informationFinance 2 for IBA (30J201) F.Feriozzi Regular exam December 15 th, 2010. Part One: MultipleChoice Questions (45 points)
Finance 2 for IBA (30J201) F.Feriozzi Regular exam December 15 th, 2010 Question 1 Part One: Multiplehoice Questions (45 points) Which of the following statements regarding the capital structure decision
More information1. a. (iv) b. (ii) [6.75/(1.34) = 10.2] c. (i) Writing a call entails unlimited potential losses as the stock price rises.
1. Solutions to PS 1: 1. a. (iv) b. (ii) [6.75/(1.34) = 10.2] c. (i) Writing a call entails unlimited potential losses as the stock price rises. 7. The bill has a maturity of onehalf year, and an annualized
More information2. What is your best estimate of what the price would be if the riskless interest rate was 9% (compounded semiannually)? (1.04)
Lecture 4 1 Bond valuation Exercise 1. A Treasury bond has a coupon rate of 9%, a face value of $1000 and matures 10 years from today. For a treasury bond the interest on the bond is paid in semiannual
More informationLESSON 28: CAPITAL ASSET PRICING MODEL (CAPM)
LESSON 28: CAPITAL ASSET PRICING MODEL (CAPM) The CAPM was developed to explain how risky securities are priced in market and this was attributed to experts like Sharpe and Lintner. Markowitz theory being
More informationEMBA in Management & Finance. Corporate Finance. Eric Jondeau
EMBA in Management & Finance Corporate Finance EMBA in Management & Finance Lecture 5: Capital Budgeting For the Levered Firm Prospectus Recall that there are three questions in corporate finance. The
More informationCapital Market Equilibrium and the Capital Asset Pricing Model
Capital Market Equilibrium and the Capital Asset Pricing Model Econ 422 Investment, Capital & Finance Spring 21 June 1, 21 1 The Risk of Individual Assets Investors require compensation for bearing risk.
More informationENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure
ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure Chapter 9 Valuation Questions and Problems 1. You are considering purchasing shares of DeltaCad Inc. for $40/share. Your analysis of the company
More informationChapter 5. Risk and Return. Copyright 2009 Pearson Prentice Hall. All rights reserved.
Chapter 5 Risk and Return Learning Goals 1. Understand the meaning and fundamentals of risk, return, and risk aversion. 2. Describe procedures for assessing and measuring the risk of a single asset. 3.
More informationDCF and WACC calculation: Theory meets practice
www.pwc.com DCF and WACC calculation: Theory meets practice Table of contents Section 1. Fair value and company valuation page 3 Section 2. The DCF model: Basic assumptions and the expected cash flows
More informationWEB APPENDIX. Calculating Beta Coefficients. b Beta Rise Run Y 7.1 1 8.92 X 10.0 0.0 16.0 10.0 1.6
WEB APPENDIX 8A Calculating Beta Coefficients The CAPM is an ex ante model, which means that all of the variables represent beforethefact, expected values. In particular, the beta coefficient used in
More informationExpected default frequency
KM Model Expected default frequency Expected default frequency (EDF) is a forwardlooking measure of actual probability of default. EDF is firm specific. KM model is based on the structural approach to
More informationBUSINESS FINANCE (FIN 312) Spring 2008
BUSINESS FINANCE (FIN 312) Spring 2008 Assignment 3 Instructions: please read carefully You can either do the assignment by yourself or work in a group of no more than two. You should show your work how
More informationChapter 11. Topics Covered. Chapter 11 Objectives. Risk, Return, and Capital Budgeting
Chapter 11 Risk, Return, and Capital Budgeting Topics Covered Measuring Market Risk Portfolio Betas Risk and Return CAPM and Expected Return Security Market Line CAPM and Stock Valuation Chapter 11 Objectives
More informationCost of Capital, Valuation and Strategic Financial Decision Making
Cost of Capital, Valuation and Strategic Financial Decision Making By Dr. Valerio Poti,  Examiner in Professional 2 Stage Strategic Corporate Finance The financial crisis that hit financial markets in
More informationFN2 Ron Muller 200708 MODULE 4: CAPITAL STRUCTURE QUESTION 1
MODULE 4: CAPITAL STRUCTURE QUESTION 1 Gadget Corp. manufactures gadgets. The average selling price of this finished product is $200 per unit. The variable cost for these units is $125. Gadget Corp. incurs
More informationCHAPTER 11: ARBITRAGE PRICING THEORY
CHAPTER 11: ARBITRAGE PRICING THEORY 1. The revised estimate of the expected rate of return on the stock would be the old estimate plus the sum of the products of the unexpected change in each factor times
More informationThe cost of capital. A reading prepared by Pamela Peterson Drake. 1. Introduction
The cost of capital A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction... 1 2. Determining the proportions of each source of capital that will be raised... 3 3. Estimating the marginal
More informationFinance 2 for IBA (30J201) F.Feriozzi Resit exam June 14 th, 2011. Part One: MultipleChoice Questions (45 points)
Question 1 Finance 2 for IBA (30J201) F.Feriozzi Resit exam June 14 th, 2011 Part One: MultipleChoice Questions (45 points) Assume that financial markets are perfect and that the market value of a levered
More informationPortfolio Performance Measures
Portfolio Performance Measures Objective: Evaluation of active portfolio management. A performance measure is useful, for example, in ranking the performance of mutual funds. Active portfolio managers
More informationChapter 5. Risk and Return. Learning Goals. Learning Goals (cont.)
Chapter 5 Risk and Return Learning Goals 1. Understand the meaning and fundamentals of risk, return, and risk aversion. 2. Describe procedures for assessing and measuring the risk of a single asset. 3.
More informationYieldCo Cost of Capital
by Josh Lutton and Shirley You Large renewable energy project developers often use a type of financing vehicle colloquially known as a YieldCo to finance portfolios of assets that are expected to have
More informationFinancial Markets and Valuation  Tutorial 6: SOLUTIONS. Capital Structure and Cost of Funds
Financial Markets and Valuation  Tutorial 6: SOLUTIONS Capital Structure and Cost of Funds (*) denotes those problems to be covered in detail during the tutorial session (*) Problem 1. (Ross, Westerfield
More informationCapital Asset Pricing Model. Joel Barber. Department of Finance. Florida International University. Miami, FL 33199
Capital Asset Pricing Model Joel Barber Department of Finance Florida International University Miami, FL 33199 Capital Asset Pricing Model Meanvariance efficient risky portfolio For each asset j =1, 2,...,
More informationSource of Finance and their Relative Costs F. COST OF CAPITAL
F. COST OF CAPITAL 1. Source of Finance and their Relative Costs 2. Estimating the Cost of Equity 3. Estimating the Cost of Debt and Other Capital Instruments 4. Estimating the Overall Cost of Capital
More informationCHAPTER 8. Problems and Questions
CHAPTER 8 Problems and Questions 1. Plastico, a manufacturer of consumer plastic products, is evaluating its capital structure. The balance sheet of the company is as follows (in millions): Assets Liabilities
More informationCHAPTER 14 COST OF CAPITAL
CHAPTER 14 COST OF CAPITAL Answers to Concepts Review and Critical Thinking Questions 1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this,
More informationAnswers to Concepts in Review
Answers to Concepts in Review 1. A portfolio is simply a collection of investments assembled to meet a common investment goal. An efficient portfolio is a portfolio offering the highest expected return
More informationThe Cost of Capital. Chapter 10. Cost of Debt (r d ) The Cost of Capital. Calculating the cost of obtaining funds for a project
The Cost of Capital Chapter 10 (def)  Cost of obtaining money to fund asset purchase  use as estimate of r (discount rate) If we can earn more than the cost of capital (r) from a project than company
More informationChapter 6. Interest Rates And Bond Valuation. Learning Goals. Learning Goals (cont.)
Chapter 6 Interest Rates And Bond Valuation Learning Goals 1. Describe interest rate fundamentals, the term structure of interest rates, and risk premiums. 2. Review the legal aspects of bond financing
More informationPractice Set #4 and Solutions.
FIN469 Investments Analysis Professor Michel A. Robe Practice Set #4 and Solutions. What to do with this practice set? To help students prepare for the assignment and the exams, practice sets with solutions
More informationEstimating Cost of Capital. 2. The cost of capital is an opportunity cost it depends on where the money goes, not where it comes from
Estimating Cost of Capal 1. Vocabulary the following all mean the same thing: a. Required return b. Appropriate discount rate c. Cost of capal (or cost of money) 2. The cost of capal is an opportuny cost
More informationFinal Exam MØA 155 Financial Economics Fall 2009 Permitted Material: Calculator
University of Stavanger (UiS) Stavanger Masters Program Final Exam MØA 155 Financial Economics Fall 2009 Permitted Material: Calculator The number in brackets is the weight for each problem. The weights
More informationChapter 3 Fixed Income Securities
Chapter 3 Fixed Income Securities Road Map Part A Introduction to finance. Part B Valuation of assets, given discount rates. Fixedincome securities. Stocks. Real assets (capital budgeting). Part C Determination
More informationAFM 472. Midterm Examination. Monday Oct. 24, 2011. A. Huang
AFM 472 Midterm Examination Monday Oct. 24, 2011 A. Huang Name: Answer Key Student Number: Section (circle one): 10:00am 1:00pm 2:30pm Instructions: 1. Answer all questions in the space provided. If space
More informationGESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE
GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE 1 ST SEMESTER 20102011 Chapter 18 Capital Budgeting and Valuation with Leverage
More informationPRACTICE EXAM QUESTIONS ON WACC
Dr. Sudhakar Raju Financial Statements Analysis (FN 6450) PRACTICE EXAM QUESTIONS ON WACC 1. The return shareholders require on their investment in a firm is called the: a. dividend yield. B. cost of equity.
More informationChapter 11 Calculating the Cost of Capital
Chapter 11 Calculating the Cost of Capital (def)  Cost of obtaining money to fund asset purchase  use as estimate of r (discount rate) If we can earn more than the cost of capital (r) from a project
More informationCOST OF CAPITAL. Please note that in finance, we are concerned with MARKET VALUES (unlike accounting, which is concerned with book values).
COST OF CAPITAL Cost of capital calculations are a very important part of finance. To value a project, it is important to discount the cash flows using a discount rate that incorporates the debtequity
More informationUniversity of Pennsylvania The Wharton School
University of Pennsylvania The Wharton School FNCE 100 PROBLEM SET #6 Fall Term 2005 A. Craig MacKinlay Capital Structure 1. The XYZ Co. is assessing its current capital structure and its implications
More informationMGT201 Solved MCQs(500) By
MGT201 Solved MCQs(500) By http://www.vustudents.net Why companies invest in projects with negative NPV? Because there is hidden value in each project Because there may be chance of rapid growth Because
More informationTaxable cash flow 556 1,485 1,530 2,308 Taxation (167) (446) (459) (692) CA tax benefits
Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2011 Answers 1 (a) Net present value evaluation of new confectionery investment Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales
More information3. You have been given this probability distribution for the holding period return for XYZ stock:
Fin 85 Sample Final Solution Name: Date: Part I ultiple Choice 1. Which of the following is true of the Dow Jones Industrial Average? A) It is a valueweighted average of 30 large industrial stocks. )
More information1 Pricing options using the Black Scholes formula
Lecture 9 Pricing options using the Black Scholes formula Exercise. Consider month options with exercise prices of K = 45. The variance of the underlying security is σ 2 = 0.20. The risk free interest
More information