Flashcards in Week 4 - Capital Markets And The pricing Of Risk Deck (31)

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1

## What is the ‘Capital Asset Pricing Model’ and what is it used for?

### The ‘Capital Asset Pricing Model’ describes the risk associated with a stock taking into account the risk of the individual stock and the risk of the market as a whole.

2

## What are the tree assumptions of the ‘CAPM’ model?

###
1. Investors can buy and sell securities at competitive market prices (without tax or transaction costs) and can borrow and lend at the risk-free interest rate.

2. Investors only hold efficient portfolio of securities ( Portfolios that yield the maximum expected return given the level of volatility).

3. Investors have homogenous expectations.

3

## What is the ‘Capital Asset Pricing Model’ (CAPM) formula?

###
CAPM = Rf+Bi (ERm-RF)

Risk free rate + Beta (Expected return of market - Risk free rate)

4

## What is the ‘Beta’ of a stock?

### The Beta of a stock is the level to which the stock corresponds to movements in the market

5

## What ‘Beta’ does the stock market as a whole have ?

### 1

6

## What does a high ‘Beta’ indicate?

### The stock moves with the market

7

## What does a low ‘Beta’ indicate?

### The stock moves more independently of the market.

8

## What does the term ‘Market capitalisation’ refer to?

### The total monetary market value of a companies outstanding shares

9

## What is ‘Market Capitalisation’ used for by investors?

### Determining a company’s size

10

## What is the formula for ‘Market capitalisation’?

### Market capitalisation = (Number of shares outstanding) x (Price per share)

11

## What is a ‘Value-Weighted portfolio’? And How is it calculated?

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The value of a security in relation to the overall portfolio.

Value-Weighted = Market Value of Shares/ Total Portfolio Value

12

## What is an ‘Equal-Opportunity’ portfolio?

###
Each stock in the portfolio is given the same amount of weighting.

Smaller firms are held at the same weight as larger firms

13

## What is an ‘Exchange-Traded Fund’ (EFT)?

### Ownership in an Exchange-Traded Fund reflects ownership in a portfolio of stock. Not individual stocks.

14

## Where does the ‘Risk-Free Rate’ come from in the US?

### The yield of U.S Treasury Bonds between a term of 10-30 years.

15

## What is the ‘Historical Risk Premium’? And What are the two drawbacks of using it?

###
The risk premium (ERm-RFR) calculated using historical data.

1. Standard Error of the estimates are large.

2. Backwards looking, so may not represent current expectations.

16

## What is the formula for calculating ‘Beta’?

### Beta = Correlation with market x Volatility of stock/ Volatility of market

17

## What is the ‘Debt-Cost of capital’? And What are the two ways it can be calculated?

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The expected return required from a firms creditors.

1. Yield to Maturity

2. Using the debt betas

18

## What is the ‘Yield to maturity’ and How is it used to calculate the debt cost of capital?

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Yield to Maturity is the IRR an investor can expect from holding a bond to maturity.

Dcc = (1-p)Y + p(Y-L)

P = Probability of default

Y = Yield to maturity

L = Expected loss per £1 of debt in the event of default

19

## What are the 3 steps to calculating the ‘Weighted Average Cost of Capital’?

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1. Calculate the Value of each security as a proportion of the firms market value.

2. Determine the required rate of return on each security.

3. Calculate a weighted average of these required returns.

20

## What is the ‘Weighted cost of Capital’?

### The weighting of debt and equity that make up the capital of a firm

21

## What is there ‘Weighted Average Cost of Capital’ formula?

### rWACC =Wdebt X Rdebt (1-t) + Wequity X Requity

22

## What is the ‘Unlevelled Cost of Capital’ rU?

### The Unlevelled Cost of Capital is equal to WACC pre-tax.

23

## In calculating WACC, the value used to achieve the weightings of both debt and Equity is not the Book value but the...

### Market value

24

## How is the market value of a debt calculated?

### PV of all coupons and par value discounted at the current interest rate

25

## How is the market value of equity calculated?

### Market price per share multiplied by the number of outstanding shares (market capitalisation)

26

## What is the ‘Pure Play Technique? And What makes a firm a ‘Pure Play’?

###
Attempts to estimate ‘Risk-adjusted required returns’ by matching a project to some publicly traded company in the same line of business.

Firms need to be as similar as possible. Consider:

- Geographical region

- Industry

- Growth stage

- Exposure to the same Operational risks

27

## What are the 6 steps in the pure play technique?

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1) Identify pure-play firms

2) Determine Betas for pure plays

3) Adjust for leverage the betas obtained

4) Re-leverage for our beta

5) Calculate the projects cost of equity

6) We can now calculate the WACC

28

## How is a Beta adjusted for leverage?

### Bu (1+(1-t)* D/E)

29

## What does holding high amounts of cash mean for a firms assets risk?And How is net debt calculated?

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High cash holdings = Lower Risk (Cash is risk-free)

Net debt = Debt - Excess Cash and Short-Term investments

30