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FIN343: Exam 3
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Terms in this set (75)
Weighted average cost of capital (WACC)
Rate used as the required rate of return in project valuation
When do we accept a project based on WACC (2)?
NPV positive or equal to 0 using WACC
IRR > WACC
How do we find the cost of equity for WACC?
Using the CAPM formula
How do we find the cost of debt for WACC?
Using the YTM on the bonds (calculator)
Time to maturity
Time left until maturity
When the principal amount is paid off
Yield to maturity
The annual rate of return the bond holder will earn if the bond is purchased and held until maturity
Coupon rate
The stated interest rate paid to the bondholder at pre-specified time intervals
Price (bond)
Price of the bond
Face value
The principal amount paid at maturity
How do you input years to maturity on the calculator when it's a semi-annual coupon?
N *2
How do you input yield to maturity on the calculator when it's a semi-annual coupon?
I /2
(if you're looking to YTM and the coupon is semi-annual, multiply your answer by 2)
How do you input price of the bond on the calculator when it's a semi-annual coupon?
PV
(if quoted in % then multiply by the face value)
What do you input in PMT when dealing with semi-annual bonds?
Coupon rate * Face value) / 2
(if looking for YTM and the coupon is semi-annual, multiply by 2)
How do you input face value on the calculator when it's a semi-annual coupon?
FV
(1000 if not stated)
What happens if coupon rate = YTM?
Bond is selling at par
What happens if coupon rate > YTM?
Bond is selling at a premium price
Price > Face value
What happens if coupon rate < YTM
Bond is selling at a discount
Price < Face value
What is interest rate risk?
Represents the sensitivity of bond prices to interest rate changes
(main risk of investing in bonds)
How are time to maturity and interest rate risk related?
The longer the time, the greater the interest rate risk
(large proportion of PV comes from face value)
How are coupon rates and interest rate risk related?
The lower the coupon rate, the greater the interest rate risk
How does interest rate risk behave?
It increase at a decreasing rate
What do you need to do to calculate % price change when the YTM changes?
Find original price of bond at original YTM
Find new price of bond at new YTM
Nominal rate
% change in dollars you have
Real rate
% change in how much you can buy with your dollars
Fisher effect
The relationship between nominal returns, real returns, and inflation
Formula for Fisher effect
nominal rate = 1+real rate) * 1 + inflation) - 1
Bond
A debt security that can be used for long-term borrowing
(usually an interest-only loan)
How are yields and bond price related?
As yields decrease, prices of the bonds increase
As yields increase, prices of the bonds decrease
How can stocks be valued (4)?
Industry valuation ratios
Constant growth model
Zero growth model
Non-constant growth model
How do we value stocks using industry valuation ratios?
EPS (net income/number of shares outstanding)
P/E ratio
What key words indicate that it's a current dividend (D0) (3)?
Just paid
Current
Paid this period
What key words indicate the dividend is paid next period (D1) (3)?
Will pay
Next payment
Expected to pay
What key words indicate that there is constant growth (3)?
Forever
Thereafter
Capital gain
What key words indicate required rate of return (R) in the constant growth model (3)?
Market rate
Required return
Expected return
How do dividends impact stock prices?
Increase in dividend leads to increase in price
How does dividend growth rate impact stock price?
Increase in dividend growth rate leads to price increase
How does the required rate of return impact stock price?
Increase in the required rate of return leads to a decrease in price
What represents the capital gain yield in calculating stock returns?
g
In general, how do we value stocks?
We need to project future dividends and then discount them to PV terms
What is the purpose of the geometric average?
It accounts for compounding
How does the geometric average compare to the arithmetic average?
It is always lower than the arithmetic average
(the difference between arithmetic and geometric average increases in volatility)
What do variance and standard deviation measure?
It measures the variability/volatility of asset returns
(lower = less risk)
Which securities historically have the highest volatility (4 from most to least)
Small stocks
Large stocks
Corporate bonds
Government bonds
What is the income value used for total percentage return for stocks and bonds?
Stocks: D1
Bonds: Coupon
How do you calculate the capital gain/loss of a bond?
P1 - P0
Arithmetic average
Return earned in an average period over multiple periods
Geometric average
Average compound return per period over multiple periods
What are risk premiums?
The extra return earned for taking on risk
Risk premium represents the return over and above the risk-free rate
What kind of investments are considered to be risk-free?
Treasury bills
Variance
The average squared deviation between actual returns and their mean
How are volatility and uncertainty related?
The greater the volatility, the more uncertain the return is
How is normal distribution defined?
It is completely defined by its mean and standard deviation
Normal distribution
A symmetric, bell-shaped frequency distribution
Not weak form efficient
Past prices, public info, and private info is not incorporated into current stock prices
Can make abnormal returns based on past prices, public info, and insider info
Weak form efficient
Past prices are incorporated into current stock prices, but public and private info is not incorporated into current stock prices
Cannot make abnormal returns based on past prices
Can make abnormal returns based on public and insider info
Semi-strong form efficient
Past prices and public info are incorporated into current stock prices, but insider info is not
Cannot make abnormal returns based on past prices or public info
Can make abnormal returns on insider info
Strong form efficient
Past prices, public info, and insider info are all incorporated into current stock prices
Cannot make abnormal returns based on past prices, public, or insider info
What are some characteristics of indexes?
They allow us to gauge how a market/market segment is performing
They are computed from the returns of underlying securities
What are the uses of indexes?
Assess market performance
Assess performance of portfolios
What are two sources of returns?
Income (dividend./coupon)
Capital gains (stock/bond price changing)
What are the 3 types of returns?
Expected
Required
Realized
Why are stock returns higher than t-bill returns?
Risk premium
How do we calculate expected returns?
Come up with probabilities different states of the economy occur
Use E(R) formula
How is systematic risk measured?
By beta
What is significant about well-diversified portfolios?
Total risk of the security is less important, what is more important is the security's movements in relation to other security's in the portfolio and the security's systematic risk
Systematic risk (5)
Exchange rate
Market risk
Interest rate risk
Reinvestment rate risk
Purchasing power risk
(nondiversifiable)
Unsystematic risk
Business risk
Financial risk
(diversifiable)
What causes stock and bond prices to change?
The flow of information
Market efficiency
The price of a stock reflects all available information
Modern Portfolio Theory
Risk averse investors can form an efficient frontier from the available assets, which is a set of portfolios they expect to provide maximum possible return for a given level of risk
Beta = 1
Asset has same systematic risk as market
Beta < 1
Asset has less systematic risk than overall market
Beta > 1
Asset has more systematic risk than market
How are beta and risk premium related?
The higher the beta, the greater the risk premium
What defines the relationship between risk and return?
Capital asset pricing model (CAPM)
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