Understanding Financial Concepts: Return, Risk, and Cost of Capital
Chapter 11: Return and Risk
Key Financial Concepts
Percentage Return: (Capital Gain + Dividend) / Initial Share Price
Dividend Yield: Dividend / Initial Share Price
Capital Gain Yield: Capital Gain / Initial Share Price
1 + Real Rate of Return: (1 + Nominal ROR) / (1 + Inflation Rate)
Risk Premium: The return differentials between risk-free treasury bills and risky securities; also known as the added return required by investors to invest in risky securities.
Average Rate of Return: R = (R1 + R2 + … + Rt) / T
Measuring Risk
Variance: Average value of squared deviations from the mean.
Var: (R1 – R)2 + (R2 – R)2 + … + (Rt – R)2 / T
Standard Deviation: Square root of the variance; the greater the variance or standard deviation, the greater the dispersion, volatility, or variability of returns, and the greater the risk.
Portfolio Risk
Expected Return: (Manually write definition)
Definition of Variance: (Manually write definition)
Diversification: Portfolio diversification is the investment in several different asset classes or sectors; diversification is not just holding a lot of assets.
Principle of Diversification: Principle stating that combining imperfectly correlated assets can produce a portfolio with less variability than the typical individual asset; diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns; this reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another; however, there is a minimum level of risk that cannot be diversified away and that is the systematic portion.
Unique Risk: Risk factors affecting only one firm or one industry; includes such things as labor strikes, part shortages, etc.
Market Risk: Economy-wide sources of risk that affect the overall stock market; include such things as changes in GDP, inflation, interest rates, etc.
Chapter 12: CAPM and Beta
Market Portfolio: Portfolio of all assets in the economy; in practice, a broad stock market index is used to represent the market.
Beta: Sensitivity of a stock’s return to the return on the market portfolio; a measure of market risk.
Portfolio Betas: Diversification decreases variability from unique risk, but not from market risk; the beta of a portfolio is an average of the betas of the securities in the portfolio, weighted by the investment in each security; if you owned all of the S&P Composite Index stocks, you would have an average beta of 1.0.
CAPM: The Capital Asset Pricing Model defines the relationship between expected return and beta: E(ri) = rf + βi(E(rM) – rf)
Total Risk: Market risk + firm-specific risk; the standard deviation of returns is a measure of total risk; for a well-diversified portfolio, unsystematic risk is very small; consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk.
Project Cost of Capital: The project cost of capital depends on the use to which the capital is being put. Therefore, it depends on the risk of the project and not the risk of the company.
Security Market Line: The expected return of this project is more than the expected return one could earn on stock market investments with the same material risk (beta). Therefore, the project’s expected return lies above the security market line and the project should be accepted.
Chapter 13: Cost of Capital and WACC
Cost of Capital: We know that the return on assets depends on the risk of the asset; the return to an investor is the same as the cost to the company; our cost of capital provides us with an indication of how the market views the risk of our assets; the cost of capital is the opportunity cost of capital for the firm’s existing assets; the cost of capital is used to assess or value new assets with risks similar to existing assets.
WACC: Weighted Average Cost of Capital; the expected rate of return on a portfolio of all the firm’s securities; taxes are an important consideration in the company cost of capital because interest payments are deducted from income before taxes are collected.
E: Market value of equity
D: Market value of debt
P: Market value of preferred stock
V: Market value of the firm = D + E + P
After-Tax Cost of Debt: Pretax cost of debt x (1 – Tax Rate) = rdebt x (1 – Tc)
WACC: [D/V x (1 – Tc)rdebt] + [E/V x requity]
WACC with Preferred Stock: WACC = [D/V x (1 – Tc)rdebt] + [E/V x requity] + [P/V x rpreferred]
Measuring Capital Structure
: In estimating WACC, do not use the book value of securities, use the market value of securities; book values often do not represent the true market value of a firm’s securities; Expected Return on Bonds: Rd = YTM; CAPM: Ri = Rf + β(rm – rf); Discount Dividend Model: Po = D0(1+g)/r-g = D1/ r-g OR r = (D0(1+g)/P0 )+g = (D1/P0) + g; Price of Preferred Stock = P0 = Div/R preferred; solve for R preferred = Div/P0; Interpreting WACC: The WACC is an appropriate discount rate only for a project that is a carbon copy of the firm’s existing business; The WACC is the rate of return that the business must expect to earn on its average risk investments in order to provide the opportunity rate of return to all its investors, debt and equity; investment project under consideration with higher or lower risk than average business risk should be discounted with rates above or below the WACC