Intermediate Corporate Finance
Intermediate Corporate Finance FINC 4531
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This 6 page Class Notes was uploaded by Justus Rippin on Tuesday October 27, 2015. The Class Notes belongs to FINC 4531 at University of West Georgia taught by Charles Hodges in Fall. Since its upload, it has received 15 views. For similar materials see /class/230215/finc-4531-university-of-west-georgia in Finance at University of West Georgia.
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Date Created: 10/27/15
Risk and Return The Basics lBasic return concepts I Basic risk concepts lStandalone risk I Portfolio market risk lRisk and return CAPMISML nus mesmtzllnn uses suues 1mm auumm 2 2 Ienuuuks 62 What are investment returns I Investment returns measure the financial results of an investment I Returns may be historical or prospective anticipated lReturns can be expressed in oDollar terms oPercentage terms nus mesmmum uses suues 1mm auumm 2 2 Iexlhnnks 6 3 What is the return on an investment that costs 1000 and is sold after 1 year for 1100 I Dollar return Received Invested 1100 1000 100 I Percentage return Returnl Invested 100I1000 010 10 Thls mesmtzllnn uses suues 1mm auumm 2 2 Ienuuuks What is investment risk lTypically investment returns are not known with certainty l Investment risk pertains to the probability of earning a return less than that expected lThe greater the chance of a return far below the expected return the greater the risk Thls mesmmum uses suues 1mm auumm 2 2 Iexlhnnks Probability distribution 20 o 15 50 return l Which stock is riskier Why nus mesmtzllnn uses suues 1mm auumm 2 2 Ienuuuks 6 6 Assume the Following Investment Alternatives usn m Economy Prob TBill E M Recession 010 80 220 280 100 130 Below avg 020 80 20 147 100 10 Average 040 80 200 00 70 150 Above avg 020 80 350 100 450 290 Boom M 80 500 200 300 430 100 nus mesmmum uses suues 1mm auumm 2 2 Iexlhnnks What is unique about the Tbill return I The Tbill will return 8 regardless of the state of the economy I Is the Tbill riskless Explain nus ruesmtzllnn uses smes 1mm auumm 2 2 lenuuuks 68 Do the returns of HT and Collections move with or counter to the economy I HT moves with the economy so it is positively correlated with the economy This is the typical situation I Collections moves counter to the economy Such negative correlation is unusual nus mesmmum uses smes 1mm auumm 2 2 lexlhnnks 69 Calculate the expected rate of return on each alternative II expected rate of return ii 01022 0202 04020 02035 01050 174 Thls ruesmtzllnn uses smes 1mm auumm 2 2 lenuuuks 6 10 A L HT 174 Market 150 USR 138 Tbill 80 Collections 17 l HT has the highest rate of return I Does that make it best Thls mesmmum uses smes 1mm auumm 2 2 lexlhnnks 611 What is the standard deviation of returns for each alternative 0 Standard deviation nus ruesmtzllnn uses smes 1mm auumm 2 2 lenuuuks a li R2R HT 6 22 174101o 2 1741020 20 174204o 35 1741020 50 1741010 2 200 nus mesmmum uses smes 1mm auumm 2 2 lexlhnnks Rate of Return nus mesmtzllnn uses suues frnrn auumm 2 2 tenuuuks lStandard deviation measures the standalone risk of an investment lThe larger the standard deviation the higher the probability that returns will be far below the expected return lCoefficient of variation is an alternative measure of standalone risk nus mesmmum uses suues frnrn auumm 2 2 Iexlhnnks Portfolio Risk and Return Assume a twostock portfolio with 50000 in HT and 50000 in Collections Calculate kl and ap Thls mesmmum uses suues frnrn auumm 2 2 Iexlhnnks 6 15 Expected Return versus Risk Expected Security return Risk 039 HT 174 200 Market 150 153 USR 138 188 Tbills 80 00 Collections 17 134 I Which alternative is best 6 17 A Portfolio Return kp kl is a weighted average k 05174 051 1 96 A A A kp is between kquot and kenquot nus mesmtzllnn uses suues frnrn auumm 2 2 tenuuuks Alternative Method Estimated Return Economy Recession Above avg Boom 12 30o1o 54020 1ooo4o 125020 150o1o 96 More nus mesmmum uses suues frnrn auumm 2 2 Iexlhnnks 619 lcp 30 962010 64 962020 100 961040 125 961020 150 962010 2 33 lap is much lower than Oeither stock 20 and 134 Oaverage of HT and Coll 167 lThe portfolio provides average return but much lower risk The key here is negative correlation nus ruesmtzllnn uses smes frnm auumm 2 2 lenuuuks TwoStock Portfolios lTwo stocks can be combined to form a riskless portfolio if r 10 l Risk is not reduced at all if the two stocks have r 10 lln general stocks have r 065 so risk is lowered but not eliminated l Investors typically hold many stocks lWhat happens when r 0 nus mesmmum uses smes frnm auumm 2 2 lexlhnnks What would happen to the risk of an average 1stock portfolio as more randomly selected stocks were added lcrp would decrease because the added stocks would not be perfectly correlated but kp would remain relatively constant Thls ruesmtzllnn uses smes frnm auumm 2 2 lenuuuks Prob 0 15 Return 61 35 6mge 20 Thls mesmmum uses smes frnm auumm 2 2 lexlhnnks 10 20 30 40 2000 Stocks in Portfolio nus ruesmtzllnn uses smes frnm auumm 2 2 lenuuuks 624 Standalone Market Diversifiable rIs 39 39 39 Market risk is that part of a security s standalone risk that cannot be eliminated by diversification Firmspecific or diversifiable risk is that part of a security s standalone risk that can be eliminated by diversification nus mesmmum uses smes frnm auumm 2 2 lexlhnnks Conclusions lAs more stocks are added each new stock has a smaller riskreducing impact on the portfolio lo39 falls very slowly after about 40 s ocks are included The lower limit for ap is about 20 cm I By forming welldiversified portfolios investors can eliminate about half the riskiness of owning a single stock nus mesmtzllnn uses suues frnm auumm 2 2 lenhuuks 626 Can an investor holding one stock earn a return commensurate with its risk INO Rational investors will minimize risk by holding portfolios lThey bear only market risk so prices and returns reflect this lower risk lThe onestock investor bears higher standalone risk so the return is less than that required by the risk nus mesmmum uses suues frnm auumm 2 2 lexlhnnks 627 How is market risk measured for individual securities lMarket risk which is relevant for stocks held in welldiversified portfolios is defined as the contribution of a security to the overall riskiness of the portfolio llt is measured by a stock s beta coefficient which measures the stock s volatility relative to the market IWhat is the relevant risk for a stock held 39 o in Isolation Thls mesmtzllnn uses suues frnm auumm 2 2 lenhuuks How are betas calculated I l Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis l The slope of the regression line which measures relative volatility is defined as the stock s beta coefficient or b Thls mesmmum uses suues frnm auumm 2 2 lexlhnnks Use the historical stock returns t calculate the beta for KWE E Market KW 1 25 7 400 2 8 0 150 3 11 0 150 4 15 0 350 5 32 5 100 6 13 7 300 7 40 0 42 0 8 10 0 100 9 10 8 250 10 131 250 nus mesmtzllnn uses suues frnm auumm 2 2 lenhuuks Calculating Beta for KWE kM 40 20 0 1721PM 40 kM 003 36 nus mesmmum uses suues frnm auumm 2 2 lexlhnnks How is beta calculated lThe regression line and hence beta can be found using a calculator with a regression function or a spreadsheet program In this example b 083 lAnalysts typically use four or five years of monthly returns to establish the regression line Some use 52 weeks of weekly returns nus ruesmtzllnn uses suues 1mm auumm 2 2 lenuuuks How is beta interpreted I If b 10 stock has average risk I If b gt 10 stock is riskier than average I If b lt 10 stock is less risky than average I Most stocks have betas in the range of 05 to 15 I Can a stock have a negative beta nus mesmmum uses suues 1mm auumm 2 2 lexlhnnks 633 Expected Return versus Market Risk Expected Security return Risk b HT 174 129 Market 150 100 USR 138 068 Tbills 80 000 Collections 17 086 l Which of the alternatives is best Thls ruesmtzllnn uses suues 1mm auumm 2 2 lenuuuks 634 Use the SML to calculate each alternative s required return lThe Security Market Line SML is part of the Capital Asset Pricing Model CAPM ISML ki kRF RPMbi lAssume kRF 8 RM kM 15 PM ku kRF 15 8 7 Thls mesmmum uses suues 1mm auumm 2 2 lexlhnnks kHT kM kUSR km 80 7000 ka nus mesmuumn Required Rates of Return 80 7129 80 90 80 7100 80 7068 80 7O86 uses suues 1mm auumm 2 2 lenuuuks 6 30 Expected versus Required Returns k k HT 174 170 Undervalued Market 150 150 USR 138 128 Tbills 80 80 Coll 17 20 Fairly valued Undervalued Fairly valued Overvalued nus mesmmum uses suues 1mm auumm 2 2 lexlhnnks
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