School

Simon Fraser UniversityDepartment

Business AdministrationCourse Code

BUS 320Professor

George BlazenkoStudy Guide

FinalThis

**preview**shows page 1. to view the full**5 pages of the document.**Key notes for final exams

Regarding MCR and ROE

Forward ROE is the rate of return that financial markets expect the firm to earn from business

investments for shareholders. The market capitalization rate is the rate of return that

shareholders expect to earn on their own on financial investments of about the same risk as the

business investment that the firm makes on their behalf.If the forward ROE exceeds

shareholdersâ€™ opportunity cost, the market capitalization rate, then the firm creates wealth for

shareholders and the market to book ratio will typically be greater than one. Therefore, the

appropriate comparison to determine whether a firm creates wealth for shareholders is the

forward ROE versus the MCR

Better investment between stocks

Higher MCR, the more wealth it generates but higher risk

ROE, MCR and Retention ration

According to the constant growth version of the DDM, if the forward ROE is lesser than the

market capitalization rate, then any dollar reinvested by the firm for the purpose of growth is

negative NPV and should not be undertaken. In this instance, share price is greater if retention

is zero, b=0, compared to a positive retention, b>0.

Share price

Share price is determined by the dividend and its dividend yield. Look at the formula.

Bond, Yield, current yield and risk

The yield on a bond is your expected rate of return. Therefore, in secondary market

trading, two bonds of equal risk must have equal yields. If this were not the case, bond

prices would change so that once more the yields on the two bonds, in equilibrium,

would be equal to one another. The yield on a bond is composed of an income

component, the current yield, and an expected capital gain or loss component. For a

premium bond there is an expected capital loss while for a discount bond there is an

expected capital gain. The sum of the current yield (coupon divided by price) and the

expected capital gain or loss (as appropriate) is your expected rate of return. It is rate

that must be the same for bonds of equal risk - even if one happens to be a discount

bond (with a lesser current yield) and the other happens to be a premium bond (with a

greater current yield).

Growth and ROE and MCR

No growth is best for firm if ROE< MCR

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MVA

Value of business investments, look back to first couple lectures notes.

Cost of capital, r,

The cost of capital is the opportunity cost of a real asset investment under consideration.

All opportunity costs are determined in financial markets. It is the expected rate of

return on a portfolio of financial assets of the same risk as the real asset investment Is

the discount rate for a business investment, It establishes the value of business investme.nt,

and therefore, it is the rate of return on the value of business investment.

Capital gain on bond

1. If rates in the economy decrease, then the yield on your bond is likely to decrease as

well. This decrease in yield will give you an unexpected capital gain over your

investment holding period less than maturity.

2. If you buy a discount bond, other things equal, that is if nothing else changes, then you

can expect the discount to dissipate as bond maturity approaches. This increase in bond

value to par at maturity gives you an â€śexpectedâ€ť capital gain.

3. If you buy either a discount bond or a premium bond immediately after a coupon and

hold it until just before it pays a coupon, then other things equal, you expect a capital

gain. The capital gain arises because you get closer to each and every coupon on the

bond and also the final par value repayment.

4. The term structure of yields in the bond market may be upward sloping. That is, yields

for longer maturity bonds tend to exceed yields for shorter term bond, other things

equal. So, if your investment holding period is less than maturity of your bond, you can

expect a capital gain on your bond investment as you â€śride down the yield curve.â€ť

Discount bond vs premium, which is better investment?

Your expected rate of return on a bond, regardless of whether it is a discount bond or a

premium bond, is the yield. So, other things equal, in particular, presuming risk and tax are

equal, there is no inherent preference for a bond investor to buy a discount bond over a

premium bond. If risk is not equal, for example for a long-term investor who faces coupon

reinvestment risk, then, even though they have the same yield, an investor might prefer the

discount bond. .

Equity investment

The market capitalization rate should guide your investment. The market capitalization rate

need not differ between stocks with low or high market/book ratios.

Determinants of mcr, r, cost of capital

Risk, and interest in economy since cost of capital is determined in financial market

Irr

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