BUS202 Study Guide

Site: Saylor Academy
Course: BUS202: Principles of Finance
Book: BUS202 Study Guide
Printed by: Guest user
Date: Tuesday, April 20, 2021, 7:27 PM

Unit 1: Introduction to Finance, Financial Statements, and Financial Analysis

1a. Explain the primary goal of financial management

  • What is the goal of financial management?
  • Why are financial managers important to firms?
  • How are the roles of shareholders and financial managers interdependent?

The primary goal of financial management for financial managers is to maximize shareholder wealth, which is also referred to as maximizing the price of the firm's existing common stock. Financial managers have to consider many factors when making decisions. They are trusted agents in firms who must engage in ethical practices to meet the firm's goals. Maximizing shareholder wealth is a goal that takes into account the risks and realities of the firm's operating environment and the impact of financial decisions. Changes in financial market stock prices are a proxy for investor sentiment toward the decisions of the firm. If investors react positively, stock price increases or stock price decreases if investors react negatively to the firm's decisions. The value of the stock price is the measure of shareholder wealth. Shareholders are the ultimate owners of a firm because each share represents a piece of the firm that has been bought. Therefore, the shareholder who purchased that stock has ownership and voting rights over the percentage of the company that shareholder owns. Financial managers should take care to make sound decisions, accounting for the appropriate operating context.

Firms are for-profit entities that provide a service or product to a market. Firms can have various organizational structures. A firm can be a sole proprietorship, self-corporation, a partnership, or a corporation. These organizational structures differ on a spectrum with regard to their taxation, legal risk, profit sharing, and the role of the financial manager. For more about what it means to own stock, watch this video.

 

1b. Describe how stocks and bonds function and their effect on corporate structure

  • From where do firms get money to operate?
  • What is a stock?
  • What is a bond?
  • How do financial markets allocate resources to firms?

Firms have a choice between two sources of raising new capital: debt or equity. A firm's owners can raise capital by selling ownership in the firm, which is equity, or a firm can secure capital by borrowing funds through a loan, which is debt. Equity is often represented by issuing stock. Debt is reflected by a firm's issuance of bonds. Financial markets are a key component to the allocation of capital to firms and to facilitating financial transactions.

Once the firm is operating, it can generate cash through other methods, such as income from its financial investments, sale of assets, operating activities, or additional-paid-in-capital by its owners. Each of these ancillary methods has at its foundation elements of debt, equity, or some combination of the two.

Whichever source of capital or combination of sources of capital chosen by a firm, that choice also has an impact on the firm's corporate structure. A firm that raises money in the capital market through equity, issues stock for sale to shareholders. In turn, those shareholders "own" a piece of the company, which provides them many entitlements, such as to vote in matters related to the firm, dividends paid on the value of the shares they own, and residual claims to the firm's assets if the firm dissolves. A firm can also raise money in the capital market by issuing a bond. When a firm issues a bond, every investor who purchases that bond is granting a loan to the firm under specified repayment terms for a specific length of time.

 

1c. Explain how financial managers use the income statement, the balance sheet, and the statement of cash flows to make better-informed decisions

  • Where do firms record their financial transactions?
  • How do firms report and track their activities to others?
  • What is the purpose of financial statements?
  • How are financial statements used to analyze a firm's operations and performance?

Firms keep official records of their operating activities, cash flows, and assets for tax purposes, general bookkeeping, regulatory reporting requirements, historical records, and information transparency to investors and other interested parties. These official records, of which there are multiple types, are collectively called financial statements. The reporting requirements can differ based on company size, firm organizational structure, and whether or not a firm is publicly or privately owned. The three most common financial statements are the balance sheet, the income statement, and the statement of cash flows. These statements are produced at least yearly and contain key accounts and activities of the firm. The statements stand individually, but they are also connected because they either share the same information or provide information that informs the creation of one of the other statements.

The balance sheet the first statement created. It gives a portrait of the company's financial position at one point in time, which is most commonly at the end of the firm's calendar year. It shows the relationship between a firm's assets (what the firm owns) and its liabilities and owner's equity (who has a claim on what the firm owns). The accounts on the balance sheet are grouped by whether they are assets, liabilities, or owner's equity. Within those categories, accounts are further separated by whether they are current (due or used within a year or less) or long-term (due or used in greater than a 12-month period). The balance sheet is governed by the equation assets = liabilities + owner's equity. For the statement to be correct, the sum of all assets must always equal the sum of liabilities and owner's equity. This maintains the balance.

The income statement is the statement of how the company has created and allocated its income over the year. The major source of a firm's income is called sales revenue. Therefore, the equation that defines the income statement is Sales – Expenses = Net Income. The income statement is connected to the balance sheet because some balance sheet accounts, especially those considered "current", are reflected as expenses on the income statement. Net Income is found at the bottom of the income statement. With net income, a firm can either reinvest it in the company by putting it into the retained earnings account, or it can pay dividends. The retained earnings account is listed on the balance sheet. A firm's tax liability and depreciation are also on the income statement.

The statement of cash flows depicts the inflow and outflows of cash within a year at a firm. It separates the cash-generating activities of the firm into three categories: operating activities, investing activities, and financing activities.

 

1d. Compute the major financial ratios in order to evaluate a company's performance

  • How are financial statements used to analyze a firm's operations and performance?
  • How do firms compare their performance across time and with their peers?

Financial statements provide a source of comparison of the firm's financial activities over time. Financial ratios are another tool that helps others evaluate a firm's performance. Financial ratios are a unique evaluation tool because they allow for the comparison of a firm's performance against its peers and against industry averages, not only against the firm's own performance. Financial ratios are percentages that are created by using various accounts on the financial statements. There are five categories of performance measured by financial ratios – liquidity or solvency, asset efficiency or turnover, profitability, financial leverage or debt, and market value. Comparisons across companies and within an industry can be done on a specific ratio, a category of ratios, or over time. Ratio analysis is a multi-dimensional analysis technique that facilitates benchmarking and trend analysis.

 

1e. Analyze pro-forma financial statements in order to evaluate the future performance of a company

  • What would a firm use to plan operations for the future?
  • How can firms use historical performance to predict future performance?
  • How do investors value a company?
  • How do pro forma financial statements differ from standard financial statements?

A firm's financial statements, while important for assessing performance, are backward-looking statements. There is a lag between when activities occur and when the reports are created. Financial statements provide information about transactions and activities that have already happened at the firm. While analysis can be conducted from existing financial statements, there are times when it's necessary to have a forward-looking perspective about the firm's activities. Therefore, financial statements are forecasted into the future, using assumptions, to create what are called "pro-forma" financial statements. It is possible to create a pro forma balance sheet, a pro forma income statement, and a pro forma cash budget.

Pro forma financial statement analysis is useful when trying to assess the future state of a firm under assumed circumstances or an anticipated change in market conditions. Pro forma financial statements are also used as a valuation method for a firm. Many firms undergoing potential sale, acquisition, merger, or buyout activities will use pro forma financial statements to estimate the firm's future worth. The assumptions used in building pro forma statements can come from market averages, benchmark metrics, or can be derived from the company's past performance as exhibited in its financial statements.

To create a pro forma statement, the firm or an analyst can use the most recent financial statement as a starting point, change assumptions for the percentage growth of each category on the financial statements, and then calculate that multiple against the current values on the financial statement used as a base. The resulting figure will be what is placed on the pro forma statement. Applying the multiple can be done for one period or many periods. The percentages applied can also be changed each iteration of creating a new statement. The result would be the creation of a pro forma statement that, using certain assumptions, gives an idea of what the future financial condition of the company could be.

 

1f. Prepare an analysis of a company's financial statements

  • What are the tools one can use to analyze a company's performance?

Financial statements contain a lot of valuable information about a firm. Analyzing financial statements is a critical exercise that allows key decisions to be made. There are many audiences for a firm's financial statements: investors, shareholders, government entities, regulatory bodies, employees, market analysts, students, and others who have an interest in learning about the organization. Being able to prepare an analysis of a firm's financial statements helps one to interpret the information on the statements. Analyzing financial statements requires one to know the equations that define the statements, the accounts and categories on the statements, the firm's baseline financial picture, and how to utilize financial ratios, common-size financial statements, and pro forma financial statements to analyze a firm. To start, it is helpful to have the balance sheet of the year in question and the balance sheet from the prior year. The firm's balance sheet from the prior year should be the starting point of the analysis because it provides the assets the company began with in the current year. The next element to examine is the income statement because it shows the sales revenue and expenses incurred from the firm's operations. The income statement also shows the additions to the retained earnings and additional-paid-in-capital accounts on the balance sheet. The depreciation expense on the income statement shows annual increases to the accumulated depreciation account on the balance sheet. Examining the statement of cash flows gives more insight into the movement of the cash account on the balance sheet it also provides insight into the operating activities on the income statement.

 

Unit 1 Vocabulary

This vocabulary list includes terms that might help you with the review items above and some terms you should be familiar with to be successful in completing the final exam for the course.

Try to think of the reason why each term is included.

  • Financial manager
  • Shareholder
  • Firm
  • Profit
  • Stock price
  • Sole proprietorship
  • Corporation
  • General partnership
  • Limited partnership
  • Limited liability company
  • Taxable income
  • Tax liability
  • Tax rate
  • Debt
  • Equity
  • Stock
  • Bond
  • Financial statement
  • Balance sheet
  • Income statement
  • Statement of cash flows
  • Ratio analysis
  • Pro-forma financial statement

Unit 2: Time Value of Money: Future Value, Present Value, and Interest Rates

2a. Explain the time value of money

  • Why does the value of money change over time?
  • How can one calculate the value of a lump sum in the future?
  • How do I find the current value of a future lump sum?

While the value of money is relatively stable in the American economy, time does have an effect on its value. Time is a measure of risk in finance. Economic conditions, inflation, interest rates, the money supply, and investor expectations all change over time, and therefore, have effects on the value of money. The saying is true that "a dollar today is worth more than a dollar tomorrow". The reason this is true is that no one can accurately predict what will happen between today and tomorrow, or even between now and the next minute. There is risk when investing or when holding money in any form for any period of time. The more money or assets that are held in forms less liquid than cash, the greater the risks. Financial calculations take into account the relationship between time and monetary value. These calculations compute what is called the "time value of money". When computing the value of money over multiple time periods, finance uses formulas to reflect that the value of a lump sum in the future (future value) or the value of a future lump sum in the present (present value) differs based on the interest rate, whether the investment earns simple or compound interest, the number of periods for which interest is earned, and the total life of the investment. When we calculate values in the future, it is called compounding. Calculating values back to the present is called discounting. To find the present value, you discount to the present. To find the future value of a lump sum, you compound into the future.

 

2b. Compute present values and future values

  • How do we calculate the future value of a lump sum?
  • How do we calculate the present value of a future lump sum?

To account for changes in the time value of money, finance has two ways of computing the value of a lump sum of money over a period of time. There are two basic questions in money valuation that an investor needs to answer: 1) How much is a lump sum worth at n periods into the future? and 2) How much is a future lump sum worth today? These questions represent the future value and the present value, respectively. To answer the first question, you need to compound; to answer the second question, you need to discount. To compound a lump sum, you multiply it by the compound factor. To discount a lump sum, you multiply it by the discount factor. The valuation of every type of financial instrument or transaction is a variation on the present value or future value computation. To accurately calculate the present or future value you need some standard inputs, such as the interest rate (which becomes the discount or compound rate), the number of times in one year the investment compounds, the total number of years in the life of the investment, and the lump sum amount. The lump-sum amount is multiplied by all of the other elements of the equation, which combine to form either a compound factor or a discount factor. The compound factor and the discount factor are inverses of each other. Future values and present values can be computed for lump sums or for multiple flows. The future value of multiple flows and the present value of multiple flows requires the same basic components.

The present value and future value equations are:

Present Value:  \frac{FV}{\left ( 1+r \right )^t}

Future Value:  PV \left ( 1+r \right ) ^t

 

2c. Compute rates of return and know their use in making financial decisions

  • How do we compute the profit earned on an investment?
  • Why is profit earned quoted as a percentage rate?

The ultimate goal of investing is to profit from the investment. In finance, the profit is called "return". The rate of return, expressed as a percent, is the ratio of the profit to the amount invested. Sometimes, firms or investors desire a certain rate of return prior to entering into a transaction. After calculating the potential value, the investor can make the decision not to enter into the transaction if the rate of return is not acceptable. A predetermined rate of return can also be used as the discount rate when valuing a transaction. A desired rate of return can be arbitrarily chosen, based on market conditions, or can be based on historical returns an investor has received.

 

2d. Explain when to apply a simple interest calculation versus a compound interest

  • What is the difference between simple interest and compound interest?

Interest is the amount paid for or earned on a transaction, depending on which side of the transaction you sit. An interest rate is simply a price paid for money, stated as a percentage of the principal or some other specified amount. There are many interest rates in the economy and they differ based on the relevant product and market.

There are two main ways to calculate interest: simple interest or compound interest. With simple interest, you only earn interest on the principal amount. Simple interest is calculated by multiplying that stated interest rate by the principal amount. The product of that operation is the amount of interest for the given period. Repeat these steps for each period that interest is earned. For the final step, sum all of the interest amounts for each period to get the total interest earned on the transaction using simple interest.

Compound interest differs from simple interest because it allows one to earn interest on their interest. This means that in the equation, over multiple periods the interest calculation includes the principal and interest from all prior periods. This results in a final amount when using compound interest that is greater than simple interest would be using the same inputs for the equation.

 

2e. Calculate the future value and present value of an amount using one period and multiple periods

  • How does the value of a lump sum when it is invested for more than one period?

Financial investments are typically held over a period of time or usually earn interest over a period of time. When calculating future or present value, the investment can last for one period or multiple periods. Each period represents a period of compounding. When computing future value, the greater number of periods, the greater the final amount. The time horizon matters, as well. The longer amount of time over which the investment compounds, the greater the final future value after multiple periods of compounding. The opposite is true of calculating the present value for multiple periods. The more frequently the investment is discounted and the longer the life of the investment, typically, the smaller the present value. When multiple periods are used, the value of n in the equations below is greater than one. Compounding for one period usually uses the word "annual", whereas compounding for multiple periods uses words other than annual, such as "daily," "continuously," "bi-annually," semi-annually," "quarterly," etc. The value of n is always written in comparison to annual terms. For example, an investment that compounds every two years (bi-annually) would have an n of 0.5, whereas something compounding every six months (semi-annually) would have an n of 2.

Try these examples:

  1. You invest $1,000 earning 5% interest compounded semi-annually. How much do you have total at the end of 3 years?
  2. You invest $1,000 earning 5% interest compounded bi-annually. How much do you have total at the end of 3 years?

 

Unit 2 Vocabulary

This vocabulary list includes terms that might help you with the review items above and some terms you should be familiar with to be successful in completing the final exam for the course.

Try to think of the reason why each term is included.

  • Time value
  • Present value
  • Future value
  • Compound
  • Discount
  • Discount rate
  • Discount factor
  • Compound factor
  • Interest rate
  • Rate of return
  • Life of the investment

Unit 3: Capital Budgeting Techniques

3a. Summarize the rules in capital budgeting when using net present value calculations

  • How do firms use money from their capital budgets to invest?
  • What is a "project" to a firm?
  • How do firms decide which projects to invest in?

Firms have finite financial resources and therefore have to make capital budgeting decisions about which capital investments to undertake. Capital investments are called projects. Firms have to make choices between which projects in which to invest by ranking projects based on the outcome of capital budgeting techniques. To do so, they use project evaluation criteria. The most common project evaluation criteria of capital budgeting are net present value (NPV) and internal rate of return (IRR). However, there are others such as the payback period, modified internal rate of return, or the average rate of returns. Each capital budgeting technique has its own decision criteria that must be considered after the return has been calculated. Net present valuation uses a technique that is called discounted cash flow valuation. Net present value is a variation on the present value calculation that allows for calculating both cash inflows and outflows and a changing discount rates and maturities. The decision criteria for an NPV calculation is as follows:

If the NPV > 0, accept the project;

If the NPV < 0, reject the project;

If the NPV = 0, accept or reject the project based on preference or other factors.

If more than one project has a positive NPV (an NPV > 0), as a rule, the project with the highest NPV should be accepted.

 

3b. Use the incremental approach in finance to compare the net present value of a project with the net present value of another project

  • How do we compare the NPV of only 2 projects?

The incremental cost approach is optimal to use when only comparing two projects. It focuses on both cost increases and decreases. Only those costs and revenues that differ between the two projects being considered are the costs and revenues to which discounted cash flow analysis need to be applied. The final result of an incremental NPV analysis should be the same as the final result from using the total cost approach of NPV, which is the more common approach.

 

3c. Calculate the depreciation expense of an asset and demonstrate how that expense factors into the income statement and cash flow statement

  • What is depreciation?
  • How does one record the depreciation of assets?
  • Which financial statements contain depreciation?

Once a firm acquires a capital asset, which is often done with the use of capital budgeting techniques, that firm is allowed to account in its financial statements for the deterioration in that asset's usefulness over time. This deterioration in the useful life of an asset is called "depreciation". Depreciation is classified as a "non-cash expense" for accounting purposes and provides a tax benefit for firms. Depreciation of an asset is an accounting convention that is used to reflect a significant loss of value or the loss of performance of an asset due to repeated use or expected maintenance over time. A firm decides based on the asset class how long it can use the asset before it will need to be replaced, re-sold, or otherwise disposed of. That length of time is called the life of the asset. Once the life of the asset is established, that becomes a very important input, almost like a target point, to calculating depreciation. Next, the firm must decide what method of depreciation to use for the asset. There are many calculation methods for depreciation. While straight-line depreciation is the most common, there are other depreciation methods, such as MACRS, modified depreciation, unit-of-service depreciation, hours-of-service depreciation, reducing balance, sum of year's digits, and double-declining balance.

Straight-line depreciation assumes that the asset will be depreciated to a value of zero by the end of its useful life and that there is no remaining book value which can be recouped from the reselling of the asset. An equal amount of depreciation is expensed each year of the asset's life until zero remains as the value of the fixed asset in its final year of life. The value of depreciation expense is constant each year while the fixed asset balance declines and the balance in the accumulated depreciation account grows.

The effect of depreciation can be seen in all three of the major financial statements – the balance sheet, income statement, and the cash flow statement. All of the depreciation over time that a company claims is reflected in the accumulated depreciation account on the balance sheet. This account is called a contra-asset. It is listed on the asset side of the balance sheet, below the capital equipment account, which is usually called Property, Plant, and Equipment (PP&E) or a fixed asset. As a contra-asset, the accumulated depreciation account maintains a growing balance, but that a balance decreases the overall asset balance instead of increasing it like a typical asset would. The accumulated depreciation account is subtracted from the balance in the fixed asset account, which creates an account that is sometimes listed on the balance sheet as a Net Fixed Asset. Whenever you see a net fixed asset account, the effects of depreciation have already been figured into the value of assets on the balance sheet. The balance in the accumulated depreciation account should increase, which the balance in the fixed asset account (or net fixed asset account) should be declining. It is possible for that balance to decline to zero.

Over time, the accumulated depreciation account will grow if assets are being actively depreciated, which means that the fixed asset account will decrease over time. The current value in the accumulated depreciation account reflects the sum of all the depreciation taken over the year or sometimes multiple years for the firm. The difference in the accumulated depreciation accounts on two consecutive years' balance sheets reflects the annual depreciation expense claimed by the firm. The annual depreciation expense is shown on the income statement of the most current year that corresponds to the most current year's balance sheet used to find the change in the accumulated depreciation accounts. When depreciation expense is on the income statement, it is known as a non-cash expense. This means that it is subtracted from sales revenue like all other expenses, but there is no actual cash outflow from the firm for having depreciation expense. Depreciation isn't paid to anyone. The "expensing" of it only happens on paper on the income statement. Expensing depreciation lowers the firm's taxable income, and in that way it provides a tax benefit. This is meant to account for anticipated future repurchases or costs associated with the asset.

The effects of depreciation are far-reaching. When trying to construct a cash flow statement for a firm, it is important to properly separate cash inflow versus outflows and to associate them with the appropriate activities. The first thing to do when assessing the cash inflows from operating activities is to add back the depreciation expense on the income statement so that the cash flow statement accurately shows that what has been depreciated is not actual cash that has flowed out of the firm. See the depreciation example below.

 

3d. Calculate the net present value of an investment option

  • What are the components of the NPV formula?
  • How can the NPV formula be modified for changes in cash flows over time?

The net present value calculation is a modification of the present value calculation. The major differences are that the equation allows for 1) cash inflows can be subtracted and these do not have to be discounted; and 2) in each period the years left to maturity will change and any other inputs to the equation can also change such as discount rate, the frequency of compounding, and even the lump sum amount that is being discounted. The equation can be expanded or shortened as needed, as the structure of the project requires.

 \mathrm{NPV}=\sum_{t=0}^{n}\frac{CF_t}{\left ( 1+r \right )^t}

 

Unit 3 Vocabulary

This vocabulary list includes terms that might help you with the review items above and some terms you should be familiar with to be successful in completing the final exam for the course.

Try to think of the reason why each term is included.

  • Discounted cash flow valuation
  • Capital budgeting
  • Decision criteria/rule
  • Net present value
  • Internal rate of return
  • Depreciation
  • Accumulated depreciation
  • Depreciation expense
  • Capital asset
  • Straight-line depreciation
  • Replacement cost
  • Salvage value

Unit 4: Risk and Return

4a. compute expected values when risk issues need to be considered in finance

  • What is risk?
  • What is reward or return?
  • What is the relationship between risk and return?
  • What types of risk are there?

Every financial transaction has an element of risk to it, meaning an investor can make money or lose money on the transaction. The gain an investor makes on a transaction is called reward or return. Risk is the uncertainty of future cash flows. There are many types of risk, such as liquidity risk, operational risk, market risk, price risk, credit risk, counterparty risk, maturity risk, default risk, geopolitical risk, and many more. For every risk, there is an accompanying risk premium. The types of risk are derived from the understanding that there is one or more element existing or event occurring that could jeopardize the cash flows expected from a transaction. In finance, the common saying is "the greater the risk, the greater the expected reward". Return is the reward one gets for bearing risk. The riskier a transaction, the greater payout one should expect. Sometimes investors want to maximize the return portion of an investment portfolio while minimizing the risk and to achieve that there are primarily three options for risk mitigation: diversification, hedging, and purchasing insurance of some type. Purchasing insurance on a financial position or investment is pretty straightforward to understand. Hedging requires investors to take an opposite and offsetting position.

Since there is a chance that an investor may not profit on a transaction, investors can compute an expected return. Expected return is the total return anticipated after taking into consideration both the expected payout and the likelihood of that payout occurring. To compute the expected value of one investment, multiply the investment's expected payout (profit or loss) times the probability that that payout will occur. This technique can be used to compare the expected value of investments so that one can determine how to best allocate funds, or it can be done for a group of investments (known as a portfolio) in which the investor is simultaneously invested to determine the total expected return of all investment's held.

 

4b. Explain why the standard deviation is used in finance as a measure of risk

  • What is the standard deviation?
  • Why is the standard deviation important in finance?

Numerically, risk is quantified in finance with a measure called the standard deviation. The standard deviation is a measure that is commonly associated with predicting expected stock returns or portfolio returns, using historical returns of a stock. The expected returns are an average of the stock's returns. The standard deviation, which is also the square root of the variance, is a measure of how volatile a stock's returns are compared to its average returns. Therefore, when investing in a financial transaction, one has an expected return that he or she estimates will be earned on a transaction if they hold the investment to maturity and if no additional risk occurs beyond what historically has occurred. Multiplying that expected return by its volatility and then by its percentage weight in the portfolio and summing all of those for each stock in a portfolio gives the expected return of the entire portfolio and is the basis of portfolio theory in finance.

 

4c. explain how the financial manager makes financial investment decisions when confronted with issues of risk and uncertainty while considering different risk preferences

  • What is risk?
  • What does it mean to be risk-averse?
  • What does the financial manager consider when balancing risk with reward?

The computation of expected value is an important financial analysis undertaken by financial managers. Expected values can be computed for many different risk scenarios, across which both the payout scenario and the probability of the payout can vary. The general practice is that financial managers invest in the portfolio of investments that yields the highest expected value. But again, to benefit from the highest expected value, the financial manager has had to accept the highest level of risk, which is not always optimal. Investors have different risk tolerances, meaning some feel more comfortable with higher risk levels, while others prefer to assume a lower level of risk and the resulting lower expected value. To reflect the varying risk preferences of investors, it is said that investors exist on a spectrum of risk averseness, which describes highly risk-averse (investors who do not want to tolerate any risk) to those with low-risk aversions (investors who can tolerate great amounts of risk).

 

4d. Analyze an investment portfolio and apply market betas to the analysis

  • What is the difference between systematic and unsystematic risk?
  • What is beta and what does it measure?
  • What is expected return?
  • What is the Capital Asset Pricing Model?
  • How does CAPM connect the concepts of risk and return?

The expected return of a stock is uncertain, there are many factors affecting stock performance and whether it ultimately generates a return. There is always a probability that the stock's performance will deviate from its historical average (expected) return, the return of a stock is also impacted by the overall performance of the stock market and an individual stock's relative behavior to the market's behavior. The measure of how a stock performs in relation to the market itself is called "beta", which is another measure of risk – systematic risk. Systematic risk is also called non-diversifiable risk or market risk. Systematic risk does not go away and is always present. Unsystematic risk is the opposite of systematic risk. It is the risk that individual securities have that can be gotten rid of; investors say that it can be "diversified away". Therefore unsystematic risk is also called diversifiable risk, asset-unique risk, or company-specific risk.

A stock can perform better than the market, the same as the market, or worse than the market depending on the value of beta. The beta of a stock is calculated using a statistical technique called regression. For the purposes of introductory finance, you will not have to use regression analysis to compute betas, but rather they will be provided for you or you will be able to solve for the beta easily by using the information in the problem.

There is more than one calculation to compute expected return. One foundational methodology developed specifically for stock returns is the Capital Asset Pricing Model, known as CAPM. The basic components of CAPM are the risk-free rate on a riskless asset in the US economy, the expected return of the stock market, and the beta of the risky asset. The CAPM allows for the computation of the expected return of a risky security, taking into consideration the stock's beta and the market risk premium, which is the expected return of the entire market minus the risk-free rate. The risk-free rate is the interest rate on a security in the economy that is believed to hold very little risk for investors, which is customarily the rate on the 1-month or 3-month US Treasury Bill. The rate on that security is considered to represent the least amount of risk to investors because the life of the security is so short and because the US government, having the highest credit rating, is almost certain not to default on its obligations.

To analyze an investment portfolio, you need to know the amount of money invested in each asset and the weight of that investment to the entire portfolio, which means the percentage of the entire portfolio amount invested in each security. You also need to know the expected return for each asset. You first need to compute the expected return for each asset, if that information is not already provided. You compute the expected return using the CAPM formula and the asset's beta. Once you have the outcome of CAPM for each security in the portfolio, you can find the expected value of the entire portfolio. The expected value of a portfolio is the sum for all assets in the portfolio, the following computation for each asset: the asset's investment amount multiplied by that asset's expected return multiplied by that asset's portfolio. The product of multiplying those three elements for each asset is then summed together with products obtained from computing the same for each asset in the portfolio. The result is the expected return of the portfolio.

 

Unit 4 Vocabulary

This vocabulary list includes terms that might help you with the review items above and some terms you should be familiar with to be successful in completing the final exam for the course.

Try to think of the reason why each term is included.

  • Risk
  • Return
  • Reward
  • Expected return
  • Expected rate of return
  • Standard Deviation
  • Stock
  • Portfolio
  • Portfolio Return
  • Beta
  • CAPM
  • Risk-free rate

Unit 5: Corporate Capital Structure, Cost of Capital, and Taxes

5a. Explain the different components of a company's capital structure

  • What is capital?
  • What are the major sources of a firm's capital?

If you recall, firms only have two sources of capital (debt and equity) or some variation of those two. Firms finance all of their activities with capital. Capital is not free. There is a cost to obtain it and to use it, and that cost is represented normally by the interest rate charged. An interest rate, if you recall, is nothing more than a price paid for money. The Weighted Average Cost of Capital (WACC) is a concept and formula designed to identify a firm's sources of capital and its cost for each form of capital in order to determine the overall average cost of capital a firm pays across all sources. The major components of a company's capital structure are common stock, preferred stock, long-term debt, and short-term debt. Common and preferred stock are equity. Long-term and short-term debts are liabilities. There are different costs for each form of capital. Each firm also has different percentages of its capital financed by each of these sources. It is possible that a firm is all-equity and has no cost for liability financing. The WACC aims to match the capital source with the cost.

 

5b. Explain the Modigliani-Miller theorem in finance

  • What does the term "capital structure" mean?
  • What is the Modigliani-Miller theorem?

Even with the use of the WACC computation within finance, capital structure is not the primary determinant of a firm's value. In fact, the Modigliani-Miller theorem states that capital structure is not a determinant at all in a firm's value. The MM theorem states that the value of a firm is based on its earning power and that that value is not affected by how a firm chooses to finance itself with debt or equity. Essentially, financing decisions are irrelevant to firm value. An addition to the theorem also states that a firm's cost of equity increases with its debt-equity ratio. The MM Theorem holds this as true given the following assumptions: no transactions costs for financial transactions, equal borrowing costs for companies and investors, the firm responsibly invests excess cash, debt financing does not affect EBIT, and firms and investors have access to the same information (there is no asymmetric information).

 

5c. Compute the market value and book value of a company

  • What is market value?
  • What is book value?
  • What are the pros and cons of each valuation method?

There are many ways to assess the value of a company. The most common methods are market value and book value. Market value is the value that is communicated by the information available in financial markets, such as stock price, the number of shares of stock a firm has in the market, and investor sentiment. The market value of a publicly-traded company = the price of one share of the company's stock × the total number of shares of stock the company currently has in the stock market. It is presumed that market value can be less stable and more reactionary, depending on economic conditions and investor expectations; however, it is a more immediate and readily-available indicator of the value of a firm. There is also an alternate way to compute a firm's market value, using the firm's assets as the basis.

In contrast, the book value of a company is a value that is primarily derived from an analysis of a company's financial statements. The balance sheet is the guiding financial statement used to assess book value. The value of the assets are used as the book value of the company.

The biggest criticism of a company's book value is that it is said to represent the historical value of a company because balance sheet assets are recorded at the prices paid at the time the asset is acquired. Over time, the value of an asset can increase or decrease, and this change in value is not always captured on the balance sheet unless the asset is sold for a gain or loss. For example, if a firm owns land – which is an asset that normally appreciates in value – the purchase price of the land appears on the balance sheet not any gains in that land's value unless the land is sold and the cash from the sale of the land is recorded. Fixed assets, such as plant, property, and equipment, will age. Even though depreciation is recorded on the balance sheet, the value attributed to depreciation might not be sufficient to cover the replacement cost of acquiring a new asset to replace one that has aged beyond use. It is also possible that the book value of the equipment underestimates the true value of the equipment because it doesn't account for the salvage value. An asset's salvage value is the amount realized from the sale of the used equipment when the firm has no further use for the equipment. To attempt to account for the intricacies of interpreting book value, some assets may be valued using a separate analysis and then added back to the firm's book value or a premium on the existing book value can be added to or subtracted from the firm's total asset value on the balance sheet.

 

5d. Apply the WACC formula for estimating a company's cost of capital

  • What is capital?
  • What is the Weighted Average Cost of Capital?

Use the problem below to practice computing the WACC.

WACC = (% of debt)(Before-tax cost of debt)(1−T) + (% of preferred stock)(cost of preferred stock) + (% of common stock)(cost of common stock)

WACC = wdrd(1 − T) + wpsrps + wsrs

A firm has $1,500,000 in debt and $1,000,000 in equity, for a total value of $2,500,000. Its cost of debt is 10% and its cost of equity is 2%. Its tax rate is 35%. What is this firm's Weighted Average Cost of Capital (WACC)? Keep in mind that, in this problem, the firm has no preferred stock.

wdrd(1 − T): (1,500,000/2,500,000)(.10)(1 - .35) = 0.039

wpsrps:(0/2,500,000)(0) = 0

wsrs: (1,000,000/2,500,000) (.02) = 0.008

WACC = .039 + 0 + .008 = 0.055 or 5.5%

 

Unit 5 Vocabulary

This vocabulary list includes terms that might help you with the review items above and some terms you should be familiar with to be successful in completing the final exam for the course.

Try to think of the reason why each term is included.

  • Balance Sheet
  • Asset
  • Fixed Asset
  • Market value
  • Book value
  • Salvage value
  • Replacement cost
  • Share of stock
  • Stock price
  • Debt
  • Equity
  • Capital Structure
  • Weighted Average Cost of Capital
  • Preferred stock
  • Common stock
  • Long-term liability

Unit 6: Applying the CAPM Model

6a. Eexplain what the CAPM measures and its components

  • What is return?
  • What is the risk-free rate?
  • How does the Capital Asset Pricing Model help to compute return?

The Capital Asset Pricing Model (known as CAPM) is the formula that measures the expected return of a risky asset. The basic components of the CAPM formula are the risk-free rate on a riskless asset in the US economy, the expected return of the stock market, and the beta of the risky asset. The CAPM allows for the computation of the expected return of a risky security, taking into consideration the stock's beta and the market risk premium, which is the expected return of the entire market minus the risk-free rate. The risk-free rate is the interest rate on a security in the economy that is believed to hold very little risk for investors, which is customarily the rate on the 1-month or 3-month US Treasury Bill. The rate on that security is considered to represent the least amount of risk to investors because the life of the security is so short and because the US government, having the highest credit rating, is almost certain not to default on its obligations.

CAPM Equation:  R_S=R_F+\left [ R+M-R_F \right ]\times \beta

 

6b. Compute a company's expected rate of return using past stock data

  • What is expected return?

The Invest-in-Us firm paid an annual dividend of $0.50 per share last month on a stock that costs $5 per share. Today the company announced that future dividends will be increasing by 3 percent annually. If you require a 12 percent rate of return, how much are you willing to pay to purchase one share of this stock today?

Try to follow this example:

First, find the future dividend for the next period and divide that by the current stock price. Then, add to that the expected growth rate and the result is the expected return.

 \frac{\left ( \$0.50 \right )\left ( 1+.03 \right )}{\$5.00}+\left ( .03 \right )=13.6\%

Next, compute the difference between the required and expected rates of return.

Required rate of return = 12% Expected rate of return = 13.6% Expected rate - required rate = 13.6% - 12.0% = 1.6%

You would be willing to pay up to 1.6% over the current stock price because that is the value of the expected return compared to what your required return. So ($5.00 × (1 + 0.16)) = $5.08.

Answer: You would be willing to pay a maximum of $5.08 for this stock

 

6c. Apply the results from the CAPM model into net present value calculations

  • What does CAPM calculate?
  • What is Net Present Value?

Using CAPM, calculate the expected return when the risk-free rate of return is 2 percent, the market risk premium is 9 percent, and the beta is 1.

Example:

Expected return of a stock or R_S=R_F+\left [ R+M-R_F \right ]\times \beta , where  R_F is the risk-free rate;  R_M is the return of the market; and  \beta is the beta of the stock.

 R_F = .02

 R_M - R_F = Market Risk Premium = .09

 \beta = 1.0

 R_S = .02 + [.09] \times 1.0 = .02 + .09 = .11 or 11%

The expected return on this stock is 11%.

Now, assume that you will receive $2,000 per year for 5 years, and use the expected return you just calculated as the discount rate. What is the net present value of those cash flows?

Example Continued:

 \mathrm{NPV}=\sum_{t=0}^{n}\frac{CF_t}{\left ( 1+R \right )^t}

 \mathrm{NPV} = \frac{\$2000}{(1+.11)^5} +\frac{\$2000}{(1+.11)^4} + \frac{\$2000}{(1+.11)^3} + \frac{\$2000}{(1+.11)^2} + \frac{\$2000}{(1+.11)^1} = \$7,391.79

 

6d. Recommend financial decisions based on a company's expected rate of return calculation

  • What is the expected rate of return?
  • What is the required rate of return?
  • What are the criteria to determine if a financial investment should be made?

The outcome of CAPM computations can be used to make financial decisions. CAPM is used to compute the expected rate of return for a stock. The answer from the CAPM equation is interpreted as a percent. Firms establish a required rate of return desired from each investment. Once you compute the expected rate of return for an investment, compare that to the firm's required rate of return. If the expected return of the investment is greater than the firm's required return, then the financial investment should be made.

 

Unit 6 Vocabulary

This vocabulary list includes terms that might help you with the review items above and some terms you should be familiar with to be successful in completing the final exam for the course.

Try to think of the reason why each term is included.

  • Beta
  • Risk
  • Return
  • Required Rate of Return
  • Expected Return
  • Capital Asset Pricing Model