### Create a StudySoup account

#### Be part of our community, it's free to join!

Already have a StudySoup account? Login here

# This course provides students with an in-depth understanding of the key financial issues faced by modern-day financial managers of corporations. It will equip students with conceptual and analytical skills necessary to make sound financial decisions. Topi FIN3101

NUS

### View Full Document

## 110

## 1

1 review

## Popular in Corporate Finance

## Popular in Business

This 49 page Class Notes was uploaded by Notetaker Notetaker on Saturday September 5, 2015. The Class Notes belongs to FIN3101 at National University of Singapore taught by Mr Daniel Ong in Summer 2015. Since its upload, it has received 110 views. For similar materials see Corporate Finance in Business at National University of Singapore.

## Reviews for This course provides students with an in-depth understanding of the key financial issues faced by modern-day financial managers of corporations. It will equip students with conceptual and analytical skills necessary to make sound financial decisions. Topi

Clutch. So clutch. Thank you sooo much Notetaker!!! Thanks so much for your help! Needed it bad lol

-*Candida Zemlak*

### What is Karma?

#### Karma is the currency of StudySoup.

#### You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!

Date Created: 09/05/15

1 1 rms Risk and Return Chapters 101112 amp 13 Outline Expected Return Variance amp Standard Deviation Covariance amp Correlation Coef cient The Return and Risk for Portfolios Diversi cation of Risk Beta as a Measure of Risk Capital Asset Pricing Model CAPM Determinants of Beta Weighted Average Cost of Capital WACC Liquidity and Cost of Capital A pendix self study Systematic and Nonsystematic Risks Arbitrage Pricing Model 13 1 SquotquotE t U5 1 Expected Return Variance amp Standard Deviation I Characteristics of individual securities that are of interest Expected Return Variance and Standard Deviation Consider a world with two risky assets stocks and bonds Assuming there is a 13 chance of each state of the economy Rate of Return Note The returns listed above are future expected returns not HUE a hlstorlcal returns 1B 2 Expected Return Variance amp Standard Deviation cont d Rate of Squared Rate of Squared Return Deviation Return Deviation Expected Return Er pg Variance 02 ZED Er2 39i U5 Standard Deviation a J2EE Em Eaa J39LD uE E51 1B3 Expected Return Variance amp Standard Deviation cont d Rate of Squared Rate of Squared E0 2191 2 4 y 12 28 11 i1 39 HUE 113 4 Expected Return Variance amp Standard Deviation cont d Rate of Squared Rate of Squared Scenario Return viation Return viation rt Er 7 i12 324 sq H LIE wu 135 Expected Return Variance amp Standard Deviation cont d Rate of Squared Rate of Squared Scenario Return viation Return 39 39 w 1 1H 1 I i M 02 2p r3 12 3324 ig289 sqoo 205 sq i1 1 H LIE w 1B6 Expected Return Variance amp Standard Deviation cont d Rate of Squared Rate of Squared Scenario Return D iation Return 39 39 0quot 25 sq 143 H LIE wu 13 7 gram 2 Covariance amp Correlation Coef cient I Covariance GSB and correlation coe icient pSB measure the degree to which the returns of the two assets move in tandem 399 r 3 u r Covariance 039 SB M i pl 35 1205 rlB 1503 1 00 lt GSB lt 00 Correlation Coef cient 1053 Z 085 0395 0393 1 lt pSB lt 1 1B8 Covariance amp Correlation Coef cient eont d Rate of Squared Rate of Squared Scenario Return Deviation Return Deviation 088 g pics ErSriB ErB i 7 1117 7 12 117 7 28 1 1 3 7 3 50 sq 1 03953 3 350 09949 m 1 0503 14382 LIE n n 1053 1B 9 3 The Return and Risk for Portfolios Rate of Squared Rate of Squared Scenario Return Deviation Return 39 39 Note that stocks have a higher expected return than bonds but higher risk higher standard deviation What is the expected return and risk of a portfolio that is 50 invested in bonds and 50 invested in stocks US i n 13 10 W25 The Return and Risk for Portfolios eont d Rate of Return Scenario Squared Deviation In each of the states the rate of return on the po folio is the weighted average of the returns on the stocks a d bonds in the portfolio Recession 130 WBVB wSrS 50 7 501 7 5 U5 Zuf39 39 lB 11 3H Du n I C a a quot N39JL Squared Deviation Scenario The expected return of the portfolio can be compute as the weighted average of the returns in each of the scenario mp y35 95 125 9 Alternatively it can be computed as the weighted average of the expected returns on the equity and the bonds Bop I wBErB I WSEFS I 5011 507 9 1B12 39u39 339 The Return and Risk for Portfolios cont d Rate of Return Scenario Squared Deviation 16 sq sq 125 1225 sq 90 rip Erp 5 92 16 sq Hus 1B 13 The Return and Risk for Portfolios eont d I I I I I I 50 16 sq 95 025 sq 125 1225 sq 90 5 sq0 308 The variance and standard deviation f the p tfolio 3 If prrzp Erp2 60 51225 295 sq i1 0P 2 J95 sq 308 Err 5 za g 1B14 f 5 The Return and Risk for Portfolios cont d Rate of Return Squared Deviation 16 sq 95 025 sq 125 1225 sq 90 95 sq 308 Alternatively the variance of the portfolio can be computed as follow If 14232032 11232052 2WBO39BWSO39 052u8162 05214312 205816u051431 95 sq Where p SB is the correlation coefficient between stock and bonds Hug and equals approximately 1 in this case computed previously 1quotf3939 39 The Return and Risk for Portfolios cont d Rate of Return Scenario Squared Deviation 16 sq 025 sq 1225 sq Observe the decrease in risk that diversi cation offers A portfolio comprising stocks and bonds has less risk lower portfolio standard deviation than stocks or bonds held in isolation and the portfolio risk is also lower than HSTIa the weighted average risk of the stocks and bonds 113 16 ENUS a 4 Diversi cation of Risk When stocks are combined to form a portfolio some of the firmspecific risks are reduced or removed Such risks are known as diversifiable risks or nansystematic risks However even if we form a portfolio with many stocks there are some risk factors that are likely to affect all the stocks in the portfolio and hence the portfolio is still subject to such risks Such risks are known as non diversifiable risks or systematic risks Since investors can remove diversi able risks simply by forming a diversi ed portfolio they should not be compensated for taking such unnecessary risks They only deserve compensation for taking nondiversifiable I iSkS 1B 17 1 7 EMS Diversi cation of Risk cont d G A Diversi able Risk Nonsystematic Risk FirmSpeci c Risk Unique Risk Portfolio risk NonDiversi able Risk Systematic Risk W Market Risk gt11 Thus diversi cation can remove some but not all of the risk of individual securities HUS 1B18 1 5 rms 5 Beta as a Measure of Risk I The common measure of risk of a security in the context of a diversi ed portfolio also known as the market portfolio is beta of the security I Beta 3 measures the responsiveness of a security to movements in the market portfolio HUS a 1B 19 Hmua Computing 3 I Theoretically beta of a stock i can be computed using statistical measures COVRLRM 0M 10m ago M a i 2 2 2 101M 0M OM 0M 0M I Strictly speaking the market portfolio M should consist of ALL investable assets in the economy In practice however a broad market index is used to represent the market portfolio M HUS 1B 20 HUS Estimating 3 in practice using Linear Regression E in 5 quot o a b O Slope Bi Market Return U5 E 1B 21 1 1 rms 6 Capital Asset Pricing Model CAPM I The Capital Asset Pricing Model CAPM allows us to compute the return necessary to compensate an investor for taking a speci c beta risk I CAPM implies that the market rewards investors only for holding nondiversi able risks and beta is the measure of such non diversi able risks I Note CAPM assumes an investor diversi es whether or not he indeed does so HUS a lB 22 1 7 The Security Market Line SML under CAPM I The SML or the CAPM formula R RF mm RF Ex ected p Rlskfree Beta of Market rlsk return on gtlt rate securlty premlum a securlty If Bi 0 then the expected return is R F If ii 1 then E EM HUS w 1B 23 The SML under CAPM cont d Return A SML M Market Risk Premium RF quota RM E gt Beta 31 1 JEan IB24 1 7 ENUS 7 Determinants of Beta I Business Risk Cyclicality of Revenues 0r Operating Income Operating Leverage I Financial Risk Financial Leverage HUE 1B 25 mua quotD Business Risk Cyclicality A cyclical rm has revenues and operating income that tend to move together With the economy Highly cyclical stocks have high betas Empirical evidence suggests that retail housing and automotive industries uctuate With the business cycle hence they have higher betas Transportation utilities and tobacco industries are less dependent upon the business cycle hence they have lower beta 1B26 mua Business Risk Operating Leverage I When a rm has a higher proportion of fixed costs and a lower proportion of variable costs it is said to have high operating leverage and if it has a lower proportion of xed costs and a higher proportion of variable costs it is said to have loW operating leverage I A rm With high xed costs cannot respond to cost adjustments quickly in a business cycle Its pro ts are therefore more a ected by changes in sales volume Therefore the rm is riskier higher beta HUS a lB 27 MENUS Business Risk Operating Leverage cont d AEBIT Total costs Fixed costs ASales Volume I Fixed costs Sales Volume For a rm with high operating leverage the operating income changes more than proportionately when sales change change in operating pro t Degree of Operating Leverage change 1n sales HUS l 93 1328 mua quotD h Financial Risk While operating leverage relates to the rm s xed costs of production nancial leverage relates to the rm s xed costs of nancing A rm with high nancial leverage has high nancial risk bankruptcy risk In the absence of tax the relationship between the betas of the rm s assets debt and equity is given by Debt Equity ASSQI De bI IBEqtu Debt Eqmly Debt Eqmly That is Asset Beta Asset is computed as the weighted average of rm s Debt Beta Debt and Equity Beta 3 Equity 1B29 1 7 ENUE Financial Risk cont d I In practice beta of debt is very low because return on debt is quite independent on market return I Assuming 3136th 0 Equity X a mm DebtEquity my Debt Equity Hence in the presence of nancial leverage equity beta will always be greater than asset beta BEquity Asset1 U5 1B 30 mua v l m r n u Hn u z Example Consider a rm that is allequity nanced ie no debt and its stock has a beta of 090 hence its asset beta is also 090 The rm now decides to lever up to 50 debt and 50 equity Since the rm has not changed its assets its asset beta should remain at 090 However its equity beta would become twice as large D bl 0 16mmin 1614356 1 e Equity 1 50 I 1B31 MUS Stability of Beta I Most analysts argue that betas are generally stable for rms remaining in the same industry and With no signi cant change in capital structure I Beta can change for the following reasons Changes in business risk Changes in nancial risk nancial leverage HUS a 1B 32 mua Industry Beta I It is frequently argued that one can better estimate a rm s beta by referring to the beta for the Whole industry This Will result in less estimation error A Simple Guideline I If you believe that the operations of the rm are similar to the operations of the rest of the industry you should use the industry beta U5 1B 33 1 7 8 Weighted Average Cost of Capital WACC I The main sources of capital for a rm are Equity Capital and Debt Capital I Equity Capital Retained earnings New equity I Debt Capital Bank borrowing Bonds HU E 1B 34 ning Computing WACC I First estimate cost of equity and cost of debt Use equity beta to estimate cost of equity rs Use YTM of bonds to estimate cost of new debt rB In the presence of corporate tax T interest is tax deductible hence the effective tax rate is rB1T I Then compute the Weighted Average Cost of Capital WA CC using the market value of equity S and market value of debt B S B r r rIJ T WACC 5BS HUS a 1B 35 NUS ua Example I A company has equity beta of 082 Riskfree rate is 8 and market risk premium is 92 I Its cost of equity VS 2 RF 16gEM RF 8 3908292 I 15 54 1B36 ning Example cont d I Existing YTM on company s bonds 8 I Corporate tax rate 37 I Market value DebttoAsset ratio 32 S B VWACC SUP 3 M BJVB 1 TC 1 0321554 O3281 037 1218 If a project s risk and leverage are the same as that of the firm then the appropriate hurdle rate to use for evaluating the project is 1218 HUS a 1B 37 ning 9 Liquidity and Cost of Capital I Recently a number of academics have argued that the expected return on a stock and the rm s cost of capital are negatively related to the liquidity of the rm s stock I If a rm s stock has low liquidity its liquidity risk Will be higher Which leads to investors demanding higher expected returns for the stock This in turn leads to higher cost of capital for the rm U5 1B 38 NUS Ej 7 7 Jr Liquidity and Cost of Capital Cost of Capital A gtLiquidity of stock U15 m E 13 39 mug If this is true What can the corporation do to i lower cost of capital I They can do the following to increase the liquidity of the rm s stock Use stock splits to increase the number of shares and reduce the price per share this could encourage trading of the stock Facilitate trading of its stock through internet ease of trading could promote active trading of the stock Increase the information ows to security analysts this could promote interest in the Hug stock 1B 40 HLIIE Appendix Self Study Systematic and Nonsystematic Risks Arbitrage Pricing Model 35 lB 41 1 3 Emus Systematic and Nonsystematic Risks I We can breakdown the risk of holding a stock into two components systematic risk and nonsystematic risk I Systematic risk is any risk that affects a large number of assets each to a greater or lesser degree such as uncertainty about GNP interest rates in ation etc Systematic risk cannot be removed by diversi cation I Nonsystematic risk is the risk that speci cally affects a single asset or a small group of assets such as poor management inef ciencies etc Nonsystematic risk can be removed by diversi cation HUS a lB 42 EENUE he 7 7 Jr Systematic and Nonsystematic Risks cont d GA RRU becomes Total risk related to a REme where m is the return that is related to systematic risk 8 is the return that is related to non systematic risk Systematic Risk related to m The surprise element of a return U is contributed by a Systematic risk m HUSH b Nonsystematic risk a 19 1343 i 7 Systematic and Nonsystematic Risks cont d I Arbitrage Pricing Model Suppose we believe that the following three systematic risk factors are sufficient to describe the systematic risks that in uence stock returns 1 In ation 2 GDP growth 3 The dollareuro spot exchange rate I Then our model can be written as R me RIBIFI GDPFGDP 18st 8 where 6 is the in ation beta GDP is the GDP beta 65 is the spot exchange rate beta F are the surprises in the systematic factors Hus w 39 51s the non systematle risk 13 44 a ning Example I Suppose we have made the following estimates 1 sf 230 2 oGDPL50 3 oSoso I Also assume that it was announced that the rm was able to attract a superstar CEO and this unanticipated development contributes 1 to the return So 3 1 I Therefore R E 230F1 150 050FS 1 HUS 1B 45 a 3 Hung ua Example cont d Note that we must identify what surprises took place in the systematic factors If the in ation rate was expected to be 3 but in fact was 8 during the time period then the surprise element is the difference between the actual and what was expected F I Surprise in in ation actual expected 8 3 5 R E 23012 150FGDP 050FS 1 E 2305150FGDP 050FS 1 1B46 1 7 Emma Example cont d I Similarly if GDP growth rate was expected to be 4 but in fact was 1 then F GDP Surprise in GDP actual expected 1 4 3 0o R E 2305150 3 0501 1 ma a lB 47 mua Example cont d If the dollareuro spot exchange rate was expected to increase by 10 but in fact remained stable during the time period then F S Surprise in exchange rate actual expected 0 10 10 R 2305150 3050 101 HUS 1B 48 1 7 EMS Example cont d I Finally if the expected return on the stock was 800 then i8 R 8 230 5 150 3 050 10 1 8 21 1 12quot ct 0f the surprise on the stock return iS 2000 HUS a 1B 49

### BOOM! Enjoy Your Free Notes!

We've added these Notes to your profile, click here to view them now.

### You're already Subscribed!

Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'

## Why people love StudySoup

#### "I was shooting for a perfect 4.0 GPA this semester. Having StudySoup as a study aid was critical to helping me achieve my goal...and I nailed it!"

#### "When you're taking detailed notes and trying to help everyone else out in the class, it really helps you learn and understand the material...plus I made $280 on my first study guide!"

#### "Knowing I can count on the Elite Notetaker in my class allows me to focus on what the professor is saying instead of just scribbling notes the whole time and falling behind."

#### "It's a great way for students to improve their educational experience and it seemed like a product that everybody wants, so all the people participating are winning."

### Refund Policy

#### STUDYSOUP CANCELLATION POLICY

All subscriptions to StudySoup are paid in full at the time of subscribing. To change your credit card information or to cancel your subscription, go to "Edit Settings". All credit card information will be available there. If you should decide to cancel your subscription, it will continue to be valid until the next payment period, as all payments for the current period were made in advance. For special circumstances, please email support@studysoup.com

#### STUDYSOUP REFUND POLICY

StudySoup has more than 1 million course-specific study resources to help students study smarter. If you’re having trouble finding what you’re looking for, our customer support team can help you find what you need! Feel free to contact them here: support@studysoup.com

Recurring Subscriptions: If you have canceled your recurring subscription on the day of renewal and have not downloaded any documents, you may request a refund by submitting an email to support@studysoup.com

Satisfaction Guarantee: If you’re not satisfied with your subscription, you can contact us for further help. Contact must be made within 3 business days of your subscription purchase and your refund request will be subject for review.

Please Note: Refunds can never be provided more than 30 days after the initial purchase date regardless of your activity on the site.