FNCE10002 Lecture Notes - Lecture 6: Expected Return, Weighted Arithmetic Mean, Standard Deviation

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amaranthbadger280

19 Jun 2018

School

University of Melbourne

Department

Finance

Course

FNCE10002

Professor

Howard Chan

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Principles of Finance

Lecture 6: Risk & Return and Portfolio Theory I

Returns on Financial Securities

The observed or realised returns of a security is measured as the change in cash flows divided by the initial

investment. This measurement can be done either continuously or discretely. Discrete is more common.

Discrete:

Continuously compounded returns:

Discrete returns typically exceed continuous returns and are more volatile over time than continuous

returns.

Geometric vs. Arithmetic Average Returns

The geometric average measures the returns earned per period from its investment over its entire time

horizon.

The arithmetic average measures returns from a single, one period investment during that time horizon.

Only the geometric average can be used to link the starting and ending values of an investment.

Where are the cash flows at time 0 and n.

The Probability Distribution Approach

We assume investors can determine possible outcomes ( and associate probabilities with these outcomes

(. For each state, cash flows are converted into rates of return using the initial investment C.

Measures of Risk and Expected Return

The expected return is the expected outcome measured as he weighted average of the individual

outcomes.

The variance or standard deviation of returns is the measure of dispersion around the expected return.

Greater dispersion = higher risk = higher uncertainty

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Document Summary

Lecture 6: risk & return and portfolio theory i. The observed or realised returns of a security is measured as the change in cash flows divided by the initial investment. This measurement can be done either continuously or discretely. Discrete returns typically exceed continuous returns and are more volatile over time than continuous returns. The geometric average measures the returns earned per period from its investment over its entire time horizon. The arithmetic average measures returns from a single, one period investment during that time horizon. Only the geometric average can be used to link the starting and ending values of an investment. Where are the cash flows at time 0 and n. We assume investors can determine possible outcomes ( and associate probabilities with these outcomes. For each state, cash flows are converted into rates of return using the initial investment c. The expected return is the expected outcome measured as he weighted average of the individual outcomes.

Related Questions

[1] The explicit costs, such as the legal expenses, associated with corporate default are classified as _____ costs.
[A] beta conversion
[B] direct bankruptcy
[C] indirect bankruptcy

[2] An indirect cost of bankruptcy is the loss of key employees.
[A] True
[B] False

[3] A legal attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a reorganization.
[A] True
[B] False

[4] The optimal capital structure has been achieved when the:
[A] weight of equity is equal to the weight of debt.
[B] debt-to-equity ratio selected results in the lowest possible weighted average cost of capital.
[C] cost of equity is maximized.

[5] The optimal capital structure will tend to include more debt for firms with:
[A] less taxable income.
[B] lower probability of financial distress.
[C] substantial tax shields from other sources.

[6] The optimal capital structure of a firm:
[A] will remain constant over time unless the firm makes an acquisition.
[B] will be the same for all firms in the same industry.
[C] will vary over time as taxes and market conditions change.

[7] In a world with corporate taxes, MM theory implies that that all firms should choose an all-debt capital structure.
[A] True
[B] False

[8] A firm is technically insolvent when:
[A] the value of its stock declines by more than 50 percent in any given 12-month period.
[B] the value of the firm's assets is less than the value of the firm's liabilities.
[C] it is unable to meet its financial obligations.

[9] Which one of the following statements is correct concerning a Chapter 7 bankruptcy?
[A] A firm reorganizes its operations in an effort to return to being a viable concern.
[B] A trustee will assume control of the firm's assets until those assets can be liquidated.

[10] If the net present value of a project is positive (non-zero), then the project's internal rate of return will exceed its required rate of return.
[A] True
[B] False

[11] Which one of these methods uses accounting values rather than financial values?
[A] AAR
[B] IRR
[C] NPV

[12] An investment should be accepted if the NPV is positive and rejected if it is negative.
[A] True
[B] False

[13] The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the:
[A] net present value.
[B] payback period.
[C] internal rate of return.

[14] An investment is acceptable if its average accounting return (AAR):
[A] exceeds the target AAR.
[B] is less than the target AAR.

[15] The discount rate that makes the net present value of an investment exactly equal to zero is called the internal rate of return.
[A] True
[B] False

[16] The most valuable investment given up if an alternative investment is chosen is referred to as a(n):
[A] sunk cost.
[B] opportunity cost.
[C] erosion cost.

[17] The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost.
[A] True
[B] False

[18] An asset will be depreciated faster using MACRS rather than the straight-line method.
[A] True
[B] False

[19] The financial break-even point determines which one of these values?
[A] Fixed costs
[B] Variable cost per unit
[C] Sales quantity

[20] The return earned in an average year over a multi-year period is called the _____ average return.
[A] arithmetic
[B] standard
[C] geometric

[21] The capital gains yield plus the dividend yield on a security is called the:
[A] geometric return.
[B] total return.
[C] variance of returns.

[22] Which one of the following is an example of a nondiversifiable risk?
[A] A poorly managed firm suddenly goes out of business due to lack of sales
[B] A key employee of a firm suddenly resigns and accepts employment with a key competitor
[C] A well respected chairman of the Federal Reserve suddenly resigns

[23] Beta values are highly dependent on the covariance of a security with the market.
[A] True
[B] False

[24] Insider trading does not offer any advantages if the financial markets are:
[A] inefficient.
[B] semiweak form efficient.
[C] strong form efficient.

[25] MM Propositions ignore bankruptcy costs.
[A] True
[B] False

blushspider431

QUESTION 1

In the lease versus buy decision, leasing is often preferable

	A.	because the lessee owns the property at the end of the least term.
	B.	because lease obligations do not affect the firm's risk as seen by investors.
	C.	because, generally, no down payment is required, and there are no indirect interest costs.
	D.	because it has no effect on the firm's ability to borrow to make other investments.
	E.	because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.

2 points

QUESTION 2

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation.

True

False

2 points

QUESTION 3

Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength.

True

False

2 points

QUESTION 4

Which of the following statements is CORRECT?

	A.	If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.
	B.	If a stock has a negative beta, its expected return must be negative.
	C.	A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
	D.	According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.
	E.	A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.

2 points

QUESTION 5

Many leases written today combine the features of operating and financial leases. Such leases are often called "combination leases."

True

False

2 points

QUESTION 6

The owner of a convertible bond owns, in effect, both a bond and a call option.

True

False

2 points

QUESTION 7

If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.

True

False

2 points

QUESTION 8

Which of the following statements is most CORRECT?

	A.	Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual.
	B.	One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
	C.	The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
	D.	Warrants have an option feature but convertibles do not.
	E.	The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.

2 points

QUESTION 9

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

True

False

2 points

QUESTION 10

The form of organization for a business is not an important issue, as this decision has very little effect on the income and wealth of the firm's owners.

True

False

2 points

QUESTION 11

Two important issues in corporate governance are (1) the rules that cover the board's ability to fire the CEO and (2) the rules that cover the CEO's ability to remove members of the board.

True

False

2 points

QUESTION 12

The "preferred" feature of preferred stock means that it normally will provide a higher expected return than will common stock.

True

False

2 points

QUESTION 13

If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.

True

False

2 points

QUESTION 14

Operating leases help to shift the risk of obsolescence from the user to the lessor.

True

False

2 points

QUESTION 15

Starting to invest early for retirement increases the benefits of compound interest.

True

False

2 points

QUESTION 16

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

True

False

2 points

QUESTION 17

Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.

True

False

2 points

QUESTION 18

An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified period of time.

True

False

2 points

QUESTION 19

The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price.

True

False

2 points

QUESTION 20

If the current price of a stock is below the strike price, then an option to buy the stock is worthless and will have a zero value.

True

False

2 points

QUESTION 21

The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds.

True

False

2 points

QUESTION 22

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

	A.	Project C, which is of above-average risk and has a return of 11%.
	B.	Project A, which is of average risk and has a return of 9%.
	C.	None of the projects should be accepted.
	D.	All of the projects should be accepted.
	E.	Project B, which is of below-average risk and has a return of 8.5%.

2 points

QUESTION 23

To finance the construction of a new plant, Pietersen Corporation must raise an additional $10,000,000 of equity capital through the sale of common stock. The firm currently has an EPS of $5.40 and a P/E ratio of 10, with 1,200,000 shares outstanding. If the firm wants its ex-rights price to be $50, what subscription price must it set on the new shares?

	A.	$39.28
	B.	$50.00
	C.	$29.55
	D.	$41.80
	E.	$33.78

2 points

QUESTION 24

Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant?

	A.	A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage.
	B.	A bank loan's nominal interest rate will always be equal to or less than its effective annual rate.
	C.	The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity.
	D.	If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%.
	E.	Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit.

2 points

QUESTION 25

Which of the following statements is CORRECT?

	A.	In the statement of cash flows, a decrease in inventories is reported as a use of cash.
	B.	In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash.
	C.	In the statement of cash flows, depreciation charges are reported as a use of cash.
	D.	In the statement of cash flows, a decrease in accounts payable is reported as a use of cash.
	E.	Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity.

2 points

QUESTION 26

The term "additional funds needed (AFN)" is generally defined as follows:

	A.	A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant.
	B.	Funds that are obtained automatically from routine business transactions.
	C.	Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations.
	D.	The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth.
	E.	The amount of assets required per dollar of sales.

2 points

QUESTION 27

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.

True

False

2 points

QUESTION 28

Which of the following statements is CORRECT?

	A.	The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.
	B.	Identifying an externality can never lead to an increase in the calculated NPV.
	C.	Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
	D.	An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase.
	E.	An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

2 points

QUESTION 29

Time lines can be constructed in situations where some of the cash flows occur annually but others occur quarterly.

True

False

2 points

QUESTION 30

A warrant is an option, and as such it cannot be used as a "sweetener."

True

False

2 points

QUESTION 31

BLW Corporation is considering the terms to be set on the options it plans to issue to its executives. Which of the following actions would decrease the value of the options, other things held constant?

	A.	The life of the option is increased, i.e., the time until it expires is lengthened.
	B.	The exercise price of the option is increased.
	C.	The Federal Reserve takes actions that increase the risk-free rate.
	D.	BLW's stock price becomes more risky (higher variance).
	E.	BLW's stock price suddenly increases.

2 points

QUESTION 32

Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?

	A.	$48.62
	B.	$40.00
	C.	$42.00
	D.	$46.31
	E.	$44.10

2 points

QUESTION 33

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price?

	A.	$18.29
	B.	$17.39
	C.	$19.22
	D.	$18.75
	E.	$17.84

2 points

QUESTION 34

If a firm's goal is to maximize its earnings per share, this is the best way to maximize the price of the common stock and thus shareholders' wealth.

True

False

2 points

QUESTION 35

The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond?

	A.	$783.75
	B.	$744.56
	C.	$825.00
	D.	$866.25
	E.	$707.33

2 points

QUESTION 36

Which of the following statements is CORRECT?

	A.	If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond.
	B.	If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium.
	C.	If a coupon bond is selling at par, its current yield equals its yield to maturity.
	D.	If a coupon bond is selling at a premium, its current yield equals its yield to maturity.
	E.	If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity.

2 points

QUESTION 37

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

True

False

2 points

QUESTION 38

Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L's IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?

	A.	Project S's NPV is more sensitive to changes in WACC than Project L's.
	B.	If the WACC is 13%, Project S will have the lower NPV.
	C.	If the WACC is 6%, Project S will have the higher NPV.
	D.	If the WACC is 10%, both projects will have positive NPVs.
	E.	If the WACC is 10%, both projects will have a negative NPV.

2 points

QUESTION 39

A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock.

True

False

2 points

QUESTION 40

Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership?

	A.	Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership.
	B.	Corporate shareholders escape liability for the firm's debts, but this factor may be offset by the tax disadvantages of the corporate form of organization.
	C.	Corporations generally find it relatively difficult to raise large amounts of capital.
	D.	Corporations generally face relatively few regulations.
	E.	Corporate investors are exposed to unlimited liability.

2 points

QUESTION 41

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

True

False

2 points

QUESTION 42

Amram Company's current ratio is 1.9. Considered alone, which of the following actions would reduce the company's current ratio?

	A.	Use cash to reduce accruals.
	B.	Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
	C.	Use cash to reduce accounts payable.
	D.	Borrow using short-term notes payable and use the proceeds to reduce accruals.
	E.	Use cash to reduce short-term notes payable.

2 points

QUESTION 43

ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent hostile takeovers.

True

False

2 points

QUESTION 44

High current and quick ratios always indicate that a firm is managing its liquidity position well.

True

False

2 points

QUESTION 45

A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

True

False

2 points

QUESTION 46

"Capital" is sometimes defined as funds supplied to a firm by investors.

True

False

2 points

QUESTION 47

Heavy use of off-balance sheet lease financing will tend to

	A.	affect a company's cash flows but not its degree of risk.
	B.	make a company appear less risky than it actually is because its stated debt ratio will appear lower.
	C.	make a company appear more risky than it actually is because its stated debt ratio will be increased.
	D.	affect the lessee's cash flows but only due to tax effects.
	E.	have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.

2 points

QUESTION 48

As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's inventories generally increase, and purchases of inventories result in more accounts payable. Thus, spontaneous liabilities that reduce AFN arise from transactions brought on by sales increases.

True

False

2 points

QUESTION 49

On the balance sheet, total assets must always equal total liabilities and equity.

True

False

2 points

QUESTION 50

The annual report contains four basic financial statements: the income statement, balance sheet, statement of cash flows, and statement of stockholders' equity.

True

False

Can you tell me What does this article tell us about the bond markets performance and the interest rate environment?

Long-Term Government Bonds Shine as Fed Goes Slow

Pimco, Vanguard funds with focus on long-term debt beat out other bond funds in the 1st quarter

For investors, one of the best bets of 2016 has been a wager via U.S. Treasurys on falling interest rates.

A Pimco long-term government-bond fund was the best performer among bond funds in the first quarter. Above, Pimco offices in Newport Beach, Calif. PHOTO: MIKE BLAKE/REUTERS

The $460 million Pimco Extended Duration Fund posted a total return of 11.8% in the first quarter, making it the best performer among 2,015 U.S.-based bond mutual funds, according to data from Morningstar. Total return reflects price gains plus periodic payments.

The runner-up was $1.3 billion Vanguard Extended Duration Treasury Index Fund, which returned 11.7% during the quarter, according to Morningstar.

Both funds posted their best returns since the last quarter of 2014 and have extended those gains in the early days of the second quarter. Duration refers to a fundâs exposure to interest-rate risk, meaning its prices will rise more when rates fall and fall more when rates rise.

Analysts have warned repeatedly that bets on duration are risky, given the long decline in interest rates over recent years. The gains are striking at a time when stocks and other riskier assets have rebounded from an early-year selloff that at one point left the Dow industrials down 10%. The Dow fell 20.55 points, or 0.1%, on Monday, but is up 0.8% for the year.

While safer securities such as U.S. Treasurys and German bunds tend to decline in price when stocks and low-rated corporate bonds rally, many analysts say the simultaneous rise of safer and riskier assets this spring is tied to the unexpectedly slow pace of policy tightening by the Federal Reserve, along with signs the global economy continues its slow healing.

FNCE10002 Lecture Notes - Lecture 6: Expected Return, Weighted Arithmetic Mean, Standard Deviation

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