Key notes for final exams bus 312.pdf

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Business Administration
BUS 320
George Blazenko

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 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. . 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 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 Payback period 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
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