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MGCR 341 FINANCE 1 Final Notes.pdf

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Management Core
MGCR 341
Greg N Gregoriou

MGCR 341 FINANCE 1 Chapter 12: Lessons from Capital Market History ο‚· Superior performance of the Canadian Index is attributed to the stability of Canadian banks and the natural resources sector ο‚· Risk-Return Trade-Off: greater the potential reward, the greater the risk (reward for bearing risk) ο‚· Total Dollar Return = Income from Investment + Capital Gain (Loss) 𝐸𝑛𝑑𝑖𝑛𝑔 π‘ƒπ‘Ÿπ‘–π‘π‘’ βˆ’ 𝐡𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 π‘ƒπ‘Ÿπ‘–π‘π‘’ ο‚· Capital Gains Yield = 𝐡𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 π‘ƒπ‘Ÿπ‘–π‘π‘’ ο‚· Time weighted returns eliminates the distorting effects created by inflows of new money, not sensitive to contributions or withdrawals o Dollar weighted returns are what investors experienced since it links the performance to the amount invested in the fund at a time ο‚· Risk premium is the return over and above the risk-free rate (excess return), small cap stocks have higher volatility than large caps (risk premium in Canada has been 4.30 percent historically) ο‚· The higher the standard deviation the more the actual returns tend to differ from the average return 2 o Standard Deviation =βˆšπ‘£π‘Žπ‘Ÿ = √ βˆ‘(𝑋 βˆ’ 𝑋) 𝑁 βˆ’ 1 ο‚· Value-at-Risk (VaR): predicts a future financial loss by back testing portfolios to find their breaking point o Banks use VaR to determine adequate capital levels since it is the maximum a bank can lose in a day ο‚· Arithmetic return is the average return of a security over a given time period VS. geometric return which 𝑛 is, g = √(1 + π‘Ÿ1)(1 + π‘Ÿ2)…(1 + π‘Ÿ 𝑛 – 1 o Long-run projected wealth levels using arithmetic averages are optimistic and short-run wealth levels using geometric are pessimistic  15-20 years or less: use the arithmetic, 20-40 years or so: split the difference between them, 40+ years: use the geometric ο‚· Markets and stocks fluctuate year-to-year due to information and their prices adjust quickly and correctly when new information arrives is the efficient market hypothesis, investors assess information o Stock prices are in equilibrium, thus it is impossible for investors to beat the market o If an efficient market is true, then you should not be able to earn abnormal or excess returns  Efficient markets do not imply that investors cannot earn a positive return in the stock market (current market prices reflect all publicly available information) o Markets are efficient due to competition among investors (more competition, more efficient) ο‚· Market efficiency will not protect an investor from making the wrong choices if they do not diversify ο‚· Weak Form: suggest that the market is highly efficient and implies that technical analysis will not lead to abnormal returns, studying past prices and volume to identify mispriced stocks o Price changes follow the random walk hypothesis, an analyst trying to identify mispriced stocks is a waste of time ο‚· Semi-Strong Form: suggests that the market is reasonably efficient and that stock prices reflect all publicly available information, analyst trying to identify mispriced stocks using statements is wasting time o Technical nor fundamental analysis will not lead to superior returns ο‚· Strong-Form: suggest that the market is not efficient and that prices reflect all information, including public and private (insider) o Not even insider information could give an investor an advantage, though evidence suggests that markets are not strong form efficient Chapter 13: Return, Risk and the Security Market Line ο‚· Risk Premium: reward for bearing risk, which can be standalone or portfolio risk ο‚· Systematic Risk: risk inherent to the entire market which affects a broad range of securities and all assets in the economy ο‚· Unsystematic Risk: can be reduced through appropriate diversification and affects only a very specific group of securities ο‚· Expected returns are based on the probabilities of possible outcomes where E =𝑖=1 𝑀𝑖 𝑖𝑅 𝑖 o To measure volatility of the returns in stocks the variance and standard deviation of stocks should be measured, 𝑛 2 2  𝜎 = √ βˆ‘ 𝑖=1𝑝𝑖(π‘…π‘–βˆ’ 𝐸 𝑅 ) NOTE: Variance is just 𝜎 ο‚· An asset’s risk and return are important in how it affects the risk and return of the entire portfolio ο‚· Correlation: tendency of two variables to move together, measure of the degree of the relationship between two variables o Perfect Positive Correlation (+1) implies that returns move up and down together o Perfect Negative Correlation (-1) implies that returns are counter-cyclical to each other ο‚· Stand-Alone Risk: if a choice had to be made between investments (mutually exclusive) that have the same expected returns but different standard deviations o Coefficient of Variation =captures the effects of both risk and return and shows the amount of 𝐸 risk per unit of return ο‚· Feasible Set: curve that comprises all of the possible portfolio combinations ο‚· Efficient Set: portion of the feasible set that only includes the efficient portfolio (maximum return is achieved for a given level of risk) ο‚· Minimum Variance Portfolio: portfolio with the largest return and with the least amount of risk ο‚· Modern Portfolio Theory: a set of optimal portfolios that offers the highest expected return for a defined level of risk o Mean-Variance Efficient Portfolio: lowest risk for the highest level of expected return (portfolios that lie below the efficient frontier are sub-optimal) ο‚· If two stocks are perfectively negative correlated, a zero variance portfolio can be achieved ο‚· Benefits to diversification whenever the correlation between two stocks is less than 1 o Build portfolios with low correlation (aim for 45 degree angle) ο‚· Total Return = Expected + Unexpected where the expected return from the stock is what shareholders expect and unexpected return derives from information sources (competitor sales, news about the firm, etc.) o The surprise component affects the stock’s price and its return, random walk hypothesis, and result in an efficient market ο‚· Risk Premium: return in excess of the risk-free rate of return that an investment is expected to yield, form of compensation for investors who tolerate the extra risk ο‚· Rational investors are concerned with the riskiness of their portfolios rather than the riskiness of individual stocks in their portfolio ο‚· Capital Asset Pricing Model (CAPM): analyzes the relationship between risk and rates of return where, o Re= R F 𝛽*(R M R )F o Drawback of the CAPM is that it requires a single measure of market (systematic) risk o Studies have shown there is no historical relationship between stock returns and their market betas, empirical failure ο‚· Diversification can reduce the variability of returns without an equivalent reduction in expected returns ο‚· NaΓ―ve Diversification: an investor simply invests in a number of different assets and hopes that the variance of the expected return on the portfolio is lowered ο‚· Markowitz Diversification: seeks to combine assets in a portfolio with returns that have low correlations, to lower the portfolio standard deviation, maximize return with lowest risk ο‚· Beta: the tendency of a stock to move up and down with the market (Ξ² = 1.00), i.e. relative risk of the market; risk-free asset Ξ² = 0.00 o Ξ² can be < 0.00, Ξ² < 1.00 implies that the asset has less systematic risk than the overall market (vice versa for Ξ² > 1.00) o Beta is relative risk, not standard deviation ο‚· Defensive Stocks: represent necessary items like food, power, water, gas, and medicine which change very little with the economic cycle ο‚· Cyclical Stocks: are highly correlated to the economy, i.e. retail and travel ο‚· R-squared represents the percentage of mutual fund or stock’s movements that can be explained by movements of an index (lowest possible R-squared is zero when two variables are entirely unrelated) o A low R-squared indicates that most of the risk of a the firm is unsystematic, a high R-squared shows that most of the risk of the firm is systematic ο‚· Security Market Line is a graphical representation of the CAPM, whose slope is the Reward-to-Risk Ratio where RRR = 𝑅𝑀 βˆ’π‘…πΉ 𝛽 ο‚· Arbitrage Pricing Theory: alternative model of risk and return and handles multiple factors that the CAPM ignores Chapter 14: Cost of Capital ο‚· Cost of capital is an expected return that investors plan to earn on their investment, i.e. a lower cost of capital helps firms to compete and move towards the goal of wealth maximization for shareholders o It is an average cost of the various sources of funds used ο‚· Cost of capital of an investment depends on the risk of that investment, cost of capital is the hurdle rate ο‚· Capital Structure: mixture of debt and equity of a firm chooses to use o The more debt a firm uses, the higher risk that it may not be able to pay back the debt, firm’s credit risk goes up by rating agencies ο‚· Capital Components: items on the RHS of the Balance Sheet and encompass various types of debt, preferred stock and equity ο‚· An optimal structure occurs when it maximizes the value of the stock (price is maximized) ο‚· Using the dividend growth model the cost of equity (e ) is estimated by, 𝐷 1 o Re= 𝑃0+ g where g can be estimated using historical growth rates o Growth can be calculated by g = (1 - Payout Rate)*ROE for companies that do not pay dividends  Simplicity of the DGM but this approach does not consider the risk (Ξ²) of the investment ο‚· Using the security market line approach the cost of equity is estimated by, o Re= R F Ξ²*(R M R )Fwhere R iF the risk free rate (T-bill rateM, R is the market ratM, RF- R is the market risk premium and Ξ² is the systematic risk of the investment  This approach adjusts for risk but requires the beta and market risk to be estimated ο‚· Cost of debt is estimated by d *(1 - Tax Rate) ο‚· Cost of preferred stock do not take into account tax adjustments since preferred dividends ate not tax 𝐷𝑝 deductible therefore Rp= 𝑃𝑝 ο‚· The value of a firm sis the combined market value of debt and equity, V = D + E, and their respective 𝐷 𝐸 weights are𝑉 + 𝑉 = 100% o WACC = βˆ‘ πΆπ‘Žπ‘π‘–π‘‘π‘Žπ‘™ π‘Šπ‘’π‘–π‘”β„Žπ‘‘ βˆ—π‘–πΆπ‘œπ‘ π‘‘ π‘œπ‘“ 𝐹𝑒𝑛𝑑 𝑖 ο‚· Economic Value Added: performance measure that analyzes if an investment is creating or destroying wealth for shareholders o It is used for searching undervalued stocks and comparing it with stock performance, if EVA is high and stock performance is poor it should turnaround o It is a complex measure which isn’t a reliable gauge of performance and has poor predictive power (proven by studies) o If the multiple of total capital and overall WACC is less than the cash flow from assets then the firm is creating value ο‚· When evaluating investments with risks significantly different from the overall firm, then the WACC can lead to poor decisions ο‚· If a firm has two divisions, with different risks associated with them, then using a single WACC would lead to incorrect decisions o Use separate divisional costs of capital if they have various projects with different risks (use pure-play or subjective approach) ο‚· Pure-Play Approach: to come up with a cost of capital for a division in a firm with multiple departments, we should identify other phone companies that focus on one line of business ο‚· Subjective Approach: firms will adopt an approach that involves making subjective adjustments to the overall WACC (different categories for different projects such as high risk, moderate risk or low risk) ο‚· A lower risk project might have good profit potential but ends up being ignored, since riskier projects have greater returns ο‚· Flotation costs incur when a firm has to issue new bonds and stocks and enlists the help of an investment bank(s) o Cost of a flotation is a function of size and risk ο‚· Flotation Costs = π΄π‘šπ‘œπ‘’π‘›π‘‘ π‘…π‘Žπ‘–π‘ π‘’π‘‘ – Amount Raised (1βˆ’πΉπ‘™π‘œπ‘‘π‘Žπ‘‘π‘–π‘œπ‘› π‘…π‘Žπ‘‘π‘’) π·βˆ—π‘“π‘‘ πΈβˆ—π‘’ o fAverage 𝑉 + 𝑉 Chapter 16: Financial Leverage and Capital Structure Policy ο‚· Afirm’schoiceof how muchdebt it shouldhaverelative to itsequity isknown asa capitalstructure decision (more debt a firm has, t
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