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# Exam #2 Study Guide 20954

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This 9 page Study Guide was uploaded by Brian Brennan on Sunday March 1, 2015. The Study Guide belongs to 20954 at University of Alabama - Tuscaloosa taught by Yuree Lim in Spring2015. Since its upload, it has received 466 views. For similar materials see FI 302- Business Finance in Business, management at University of Alabama - Tuscaloosa.

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Date Created: 03/01/15

FI 302Business Finance Fl 302Business Finance Chapter 6 Notes February 12 2015 Chapter 6 Outline 61 An Introduction to Statistics 62 Interest Rates and Credit Risk Default Risk 63 Uncertainty in Capital Budgeting 64 Splitting Uncertain Project Payoffs into Debt and Equity What is a fair bet A fair bet is a bet that costs its expected value In other words you get what you pay for If the bet is made over and over both sides come out even If the cost of the bet equals its expected value then it is fair Fair Bet Example What is the expected value of a bet that has these payoffs 167400 33310 520 1400 you would pay 1400 ifyou wanted to break even in the long term Standard deviation risk square root of the variance 4142 0142 20142 600 risk of the bet What is the difference between risk averse and risk neutral investors For now we assume risk neutral investors they take fair bets To a risk neutral investor all fair bets are taken They will take a certain 1 or a 5050 chance to earn 0 or 2 Risk neutral investors are motivated by the payoff they expect not risk Risk averse investors will take the certain 1 over the 5050 chance Both alternatives have an expected value of 1 but risk averse investors require a higher return than risk neutral investors to take a fair bet What are the two groups of bonds 1 Investment Grade highquality borrowers 03 chance of default 2 SpeculativeJunk low quality borrowers 3555 chance of default What is a limited liability You are on the hook for only what you invested and no more Most financial securities offer limited liabilities Shareholders can only lose the value of their stock and no more F 302Business Finance Fl 302Business Finance Chapter 8 Notes February 16 2015 Outline 81 Measuring Risk and Reward 82 Portfolios Diversification and Investor Preferences 83 How to Measure Risk Contribution 84 Expected Rates of Return and Market Betas for Weighted Portfolios and Firms 85 Calculations for Risk and Reward Problem ER13 Answer 1410 At the beginning of last month about 30 of your 5000 portfolio was in stock X stock Y accounted for 30 and stock 2 for the rest Monthly rates of return equaled 16 for stock X 15 for Y and 12 for Z Find last month39s percentage change in total portfolio wealth Find last month s change in portfolio wealth There is 5000 in portfolio Weight Return Stock X 30 16 Stock Y 30 15 Stock 2 40 12 Change in Stock Price EndBeginning Rate of Return Beginning ERp wx E RX wy E Ry w E R2 316 315 13312 01410 1410 Problem ER3 Answer 6415 The expected rate of return on common stock for company X equals 76 For Company Y the expected rate of return is 129 You wish to form a portfolio by allocating some of your funds in Company X and the remainder in Company Y In order to form a portfolio whose expected return equals 950 what proportion of funds should be invested in Company X Find the weight in company X Rx 76 RV 129 Rp 95 WX F 302Business Finance ERporfolio Wxrx Wyry 095 WX076 1Wx129 076Wx 129 129wy 129 076Wx 129 095 w 129095129 076 6415 Weight in X 6415 Weight in Y 16415 3585 Problem ER5 Answer X is dominant for standard deviation Y is better for Expected Returnthere is a tradeoff Find standard deviation for X and Y Expected Return Sum of Probability x Outcome Standard Dev Sum of Probability Outcome ER12 Expected Return Expected return for X Probability x Outcome 4 x 003 3 x 104 3 x 142 0726 Expected return for Y 4 x 054 3 x 231 3 x 154 0939 Standard Deviation Standard Dev For x 4003 07262 3104 07262 3142 0726212 0636 636 Standard Dev For Y 4054 09392 323 09392 3154 0939212 124 124 Problem ER12 The rates of return listed below for securities X and Y are equally likely Find the standard deviation and expected rates of return for securities X and Y and also compare the two regarding dominance or tradeoff ROR for X 11 95 195 159 ROR for Y 235 165 137 43 Expected Return for X 25 011250952519525159 1095 Expected Return for Y 25235 25165 25137 25 043 1235 Standard Deviation x 25o11 10952 2509510952 25195 10952 25159 1095212 F 302Business Finance Problem ER16 Po 1300 Non Dividend paying company Probability B One 25 2400 Two 10 3700 None 1002510 65 000 N Find expected return Formula ROR 24 1313 25241313 10371313 6501313 2115 1846 65 2539 2539 3 Find standard deviation risk 25 241313 25392 10 371313 25392 6501313 2539212 3025 4410 3618 2 10513 RISK Problem ERZc Probability amp y Declining 30 27 41 Flat 35 95 201 Rising 35 191 96 1 Find expected return for each portfolio will have 3 different scenarios 45 027 55 041 0104 45 095 55 201 1533 45 191 55 096 0332 2 Expected Return 3 0104 35 1533 35 0332 68 F 302Business Finance 3 Standard Deviation 301040682 3515330682 350332 06821392 0627 F 302Business Finance Fl 302Business Finance Chapter 9 Problems February 23 2015 Outline 91 What You Already Know and What You Want to Know 92 The Capital Asset Pricing Model CAPM A Cookbook Recipe Approach 93 The CAPM Cost Of Capital in the Present Value Formula 94 Estimating the CAPM Inputs 95 Empirical Evidence Is the CAPM the Right Model What are the three inputs needed for CAPM 1 Risk free rate of return 2 The expected market rate of return 3 The market beta Compare Beta values with risk of market Correlation tells you direction as in same vs opposite direction Comovement includes correlation with the amplitude of movement We can quantify comovement as the slope of a line plotting stock returns vs market returns This slope is called the market beta of the stock Draw the security market line if the true expected rate of return on the market is 6 per annum and the risk free rate is 2 per annum positive relationship between beta and rate of return slope is market risk premium y mx b for this question mark yintercept at 2 and slope at 624 Problem AP1a Answer C Add either one since for both the expected returns exceed Required returns rexpected return lt rrequired 9 SELL rexpected return gt rrequired 9 BUY a Expected Return 1170 B 69 b Expected Return 1760 B 146 CAPM rA r1BArm rf 066 69 129 066 1095 expected return is greater than CAPM BUY will add stock A to portfolio F 302Business Finance CAPM r3 r1BArm rf 066 146129 066 1580 expected return is greater than CAPM BUY will add stock B to portfolio Problem AP5b Answer e Buy it 8075 Growth Rate 88 Dividendo 135 P0 V0 Market Risk Premium 95 Divident Growth Model V0 divlrg for growing dividend CAP39V39 mm rf 8 rm n 06 75 X 095 1313 1313 rI eqUIred V0 diV1r398 2098 1351 088r088 2098r 088 135 x 1088 2098r 2098 x 088 135 x 1088 r 1580 158 remadequot PROBLEM AP8 Real risk free 25 Inflation 40 Market risk premium 90 B 155 Dividend growth 25 Just paid a dividend of 105 per share What is the percentage change in V intrinsic value Ending valuebeginning valuebeginning value Use divrg for growing dividend div11grg F 302Business Finance Rate of Return Beginning CAPM r rf B rmrf Ginside parentheses is market risk premium 025 04 155 x 09 2045 End 025 04 155 x 09 01 MRP increases by 100 bp 22 Now find intrinsic value using formula 1051 0252045025 59958 And Ending intrinsic value 1051012522 025 55192 Final Answer 551925995859958 0795 PROBLEM AP9 Real rf 40 Inflation premium 15 Market risk premium 85 B 180 9140 g 6 9 750 Dividend 90 Rate of Return see formulas above Beginning 04 015 180 x 085 2080 End 04 015 140 x 085 1740 Now calculate intrinsic value Beginning 901 062080 06 64459 Ending 901 0751740075 97727 Final Answer 97727 6445964459 5161 F 302Business Finance Fl 302Business Finance Chapter 7 Problems March 2 2015 Chapter 7 Outline 71 Stocks Bonds and Cash 1970 2012 72 A Brief Overview of Equityrelated Market Institutions Rank the following asset categories in terms of risk cash money market longterm bonds the stock market and a typical individual stock 1 Cash Liquid lowrisk shortterm debt securities CDs saving deposits commercial paper 3 2 Bonds Debt securities with longer maturities government corporate 2 3 Stocks Grouped by size or other characteristics 1 Is the average individual stock safer or riskier than the stock market Portfolios of many stocks have less risk than individual stocks This characteristic is called diversification What are the two main mechanisms by which a privately held company can go public 1 Initial Public Offering IPO the first time shares are sold to the public and institutions 2 Reverse merger when a private firm buys a publicly held firm

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