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
shareholders’ 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 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 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 “expected” 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 “ride down the yield curve.”
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. .
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 The internal rate of return is the rate of return on a real asset investment (tangible
investment). It is calculated as the hypothetical discount rate which makes the NPV
calculation equal to zero. If the IRR on an investment exceeds the opportunity cost,
then the investment is acceptable. Generally, the IRR rule for real asset investment and
the NPV rule lead to the same investment decision. The principal determinant of the
IRR on a new venture is its profitability
The payback period is the number of years which it takes to recoup an original
expenditure in terms of after tax operating cashflows (i.e., FCF). There is no natural
benchmark for the payback p