Week 4 - Capital Markets And The pricing Of Risk

Question 1

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

Answer 1

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.

Question 2

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

Answer 2

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.

Question 3

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

Answer 3

CAPM = Rf+Bi (ERm-RF)

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

Question 4

What is the ‘Beta’ of a stock?

Answer 4

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

Question 5

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

Answer 5

1

Question 6

What does a high ‘Beta’ indicate?

Answer 6

The stock moves with the market

Question 7

What does a low ‘Beta’ indicate?

Answer 7

The stock moves more independently of the market.

Question 8

What does the term ‘Market capitalisation’ refer to?

Answer 8

The total monetary market value of a companies outstanding shares

Question 9

What is ‘Market Capitalisation’ used for by investors?

Answer 9

Determining a company’s size

Question 10

What is the formula for ‘Market capitalisation’?

Answer 10

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

Question 11

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

Answer 11

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

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

Question 12

What is an ‘Equal-Opportunity’ portfolio?

Answer 12

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

Smaller firms are held at the same weight as larger firms

Question 13

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

Answer 13

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

Question 14

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

Answer 14

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

Question 15

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

Answer 15

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.

Question 16

What is the formula for calculating ‘Beta’?

Answer 16

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

Question 17

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

Answer 17

The expected return required from a firms creditors.

1. Yield to Maturity
2. Using the debt betas

Question 18

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

Answer 18

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

Question 19

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

Answer 19

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.

Question 20

What is the ‘Weighted cost of Capital’?

Answer 20

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

Question 21

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

Answer 21

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

Question 22

What is the ‘Unlevelled Cost of Capital’ rU?

Answer 22

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

Question 23

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

Answer 23

Market value

Question 24

How is the market value of a debt calculated?

Answer 24

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

Question 25

How is the market value of equity calculated?

Answer 25

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

Question 26

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

Answer 26

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

Question 27

What are the 6 steps in the pure play technique?

Answer 27

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

Question 28

How is a Beta adjusted for leverage?

Answer 28

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

Question 29

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

Answer 29

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

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

Question 30

What is ‘Operating Leverage’?

Answer 30

Operating leverage is the relative proportion of fixed versus variable costs.

Question 31

When a firm has higher Fixed Costs, how should the ‘Cost of Capital’ reflect this?

Answer 31

The cost of capital should be higher