FIN 480 EXAM 1 STUDY GUIDE
Gordon Growth Model - Answers - A model for determining the intrinsic value of a stock,
based on a future series of dividends that grow at a constant rate. Given a dividend per
share that is payable in one year, and the assumption that the dividend grows at a
constant rate in perpetuity, the model solves for the present value of the infinite series of
future dividends.
P=D/(k-G)
Where:
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
Because the model simplistically assumes a constant growth rate, it is generally only
used for mature companies (or broad market indices) with low to moderate growth
rates.
CAPM - Answers - A model that describes the relationship between risk and expected
return and that is used in the pricing of risky securities.
Capital Asset Pricing Model (CAPM)
The general idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk. The time value of money is represented by the risk-free
(rf) rate in the formula and compensates the investors for placing money in any
investment over a period of time. The other half of the formula represents risk and
calculates the amount of compensation the investor needs for taking on additional risk.
This is calculated by taking a risk measure (beta) that compares the returns of the asset
to the market over a period of time and to the market premium (Rm-rf).
The CAPM says that the expected return of a security or a portfolio equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet or beat the
required return, then the investment should not be undertaken. The security market line
plots the results of the CAPM for all different risks (betas).
Using the CAPM model and the following assumptions, we can compute the expected
return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk
measure) of the stock is 2 and the expected market return over the period is 10%, the
stock is expected to return 17% (3%+2(10%-3%)).
WACC - Answers - Cost Of Capital - Weighted Average Cost Of Capital (WACC)
Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in
which each category of capital is proportionately weighted. All capital sources - common
,stock, preferred stock, bonds and any other long-term debt - are included in a WACC
calculation. All else equal, the WACC of a firm increases as the beta and rate of return
on equity increases, as an increase in WACC notes a decrease in valuation and a
higher risk.
The WACC equation is the cost of each capital component multiplied by its proportional
weight and then summed:
WACC = E/V*Re + D/V*Rd*(1-Tc)
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Broadly speaking, a company's assets are financed by either debt or equity. WACC is
the average of the costs of these sources of financing, each of which is weighted by its
respective use in the given situation. By taking a weighted average, we can see how
much interest the company has to pay for every dollar it finances.
A firm's WACC is the overall required return on the firm as a whole and, as such, it is
often used internally by company directors to determine the economic feasibility of
expansionary opportunities and mergers. It is the appropriate discount rate to use for
cash flows with risk that is similar to that of the overall firm. (Learn more in Evaluating A
Company's Capital Structure.)
Standard Deviation - Answers - 1. A measure of the dispersion of a set of data from its
mean. The more spread apart the data, the higher the deviation. Standard deviation is
calculated as the square root of variance.
2. In finance, standard deviation is applied to the annual rate of return of an investment
to measure the investment's volatility. Standard deviation is also known as historical
volatility and is used by investors as a gauge for the amount of expected volatility.
, The discount rate can be interpreted as - Answers - the riskiness of expected future
cash flow
Cost of Capital (2) - Answers - Determine the firm's expected required return
Analyze the capital structure and how it impacts
the cost of capital
Financing Decision - Answers - A decision on how to raise money needed for a firm's
investments in real assets.
Therefore financing decisions impact the discount rate
Value comes from - Answers - Cash flows
Growth
Risk
Review slideshow 1 on annuity, trunkated CF, etc - Answers - ...
Nominal rate & Real rate - Answers - Actual rate of return
Rate adjusted for inflation, i.e. the return in today's dollars.
If using actual dollars, then discount with
nominal rate
If using constant dollars, then discount with
real rate
FCF is cash.... - Answers - available to distribute to stockholders and bondholders
FCF represents returns to all
financing
2 principal methods for calculating FCF - Answers - Indirect and direct method
Indirect method
○ Starts with the firm's Profit After Tax (PAT)
Direct method
○ Starts with Revenues
See PAT calc on first slideshow - Answers - ...
Gordon Growth Model - Answers - A model for determining the intrinsic value of a stock,
based on a future series of dividends that grow at a constant rate. Given a dividend per
share that is payable in one year, and the assumption that the dividend grows at a
constant rate in perpetuity, the model solves for the present value of the infinite series of
future dividends.
P=D/(k-G)
Where:
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
Because the model simplistically assumes a constant growth rate, it is generally only
used for mature companies (or broad market indices) with low to moderate growth
rates.
CAPM - Answers - A model that describes the relationship between risk and expected
return and that is used in the pricing of risky securities.
Capital Asset Pricing Model (CAPM)
The general idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk. The time value of money is represented by the risk-free
(rf) rate in the formula and compensates the investors for placing money in any
investment over a period of time. The other half of the formula represents risk and
calculates the amount of compensation the investor needs for taking on additional risk.
This is calculated by taking a risk measure (beta) that compares the returns of the asset
to the market over a period of time and to the market premium (Rm-rf).
The CAPM says that the expected return of a security or a portfolio equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet or beat the
required return, then the investment should not be undertaken. The security market line
plots the results of the CAPM for all different risks (betas).
Using the CAPM model and the following assumptions, we can compute the expected
return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk
measure) of the stock is 2 and the expected market return over the period is 10%, the
stock is expected to return 17% (3%+2(10%-3%)).
WACC - Answers - Cost Of Capital - Weighted Average Cost Of Capital (WACC)
Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in
which each category of capital is proportionately weighted. All capital sources - common
,stock, preferred stock, bonds and any other long-term debt - are included in a WACC
calculation. All else equal, the WACC of a firm increases as the beta and rate of return
on equity increases, as an increase in WACC notes a decrease in valuation and a
higher risk.
The WACC equation is the cost of each capital component multiplied by its proportional
weight and then summed:
WACC = E/V*Re + D/V*Rd*(1-Tc)
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Broadly speaking, a company's assets are financed by either debt or equity. WACC is
the average of the costs of these sources of financing, each of which is weighted by its
respective use in the given situation. By taking a weighted average, we can see how
much interest the company has to pay for every dollar it finances.
A firm's WACC is the overall required return on the firm as a whole and, as such, it is
often used internally by company directors to determine the economic feasibility of
expansionary opportunities and mergers. It is the appropriate discount rate to use for
cash flows with risk that is similar to that of the overall firm. (Learn more in Evaluating A
Company's Capital Structure.)
Standard Deviation - Answers - 1. A measure of the dispersion of a set of data from its
mean. The more spread apart the data, the higher the deviation. Standard deviation is
calculated as the square root of variance.
2. In finance, standard deviation is applied to the annual rate of return of an investment
to measure the investment's volatility. Standard deviation is also known as historical
volatility and is used by investors as a gauge for the amount of expected volatility.
, The discount rate can be interpreted as - Answers - the riskiness of expected future
cash flow
Cost of Capital (2) - Answers - Determine the firm's expected required return
Analyze the capital structure and how it impacts
the cost of capital
Financing Decision - Answers - A decision on how to raise money needed for a firm's
investments in real assets.
Therefore financing decisions impact the discount rate
Value comes from - Answers - Cash flows
Growth
Risk
Review slideshow 1 on annuity, trunkated CF, etc - Answers - ...
Nominal rate & Real rate - Answers - Actual rate of return
Rate adjusted for inflation, i.e. the return in today's dollars.
If using actual dollars, then discount with
nominal rate
If using constant dollars, then discount with
real rate
FCF is cash.... - Answers - available to distribute to stockholders and bondholders
FCF represents returns to all
financing
2 principal methods for calculating FCF - Answers - Indirect and direct method
Indirect method
○ Starts with the firm's Profit After Tax (PAT)
Direct method
○ Starts with Revenues
See PAT calc on first slideshow - Answers - ...
