Topics: Net present value, Internal rate of return, Rate of return Pages: 17 (2221 words) Published: September 23, 2014
Theory of Finance Exam
Taught by: Tana Chasakara

Feedback from Last session
•  I move to fast through the material

•  I will slow down this time and go
over 2 hours if necessary

•  I should correspond with Prof Bower

•  Met with Professor Bower and
created my slides based on the
information she provided

•  Some one on one time would be
really helpful

•  I will be in the library tomorrow from
12.30-3.30 if you need help with
specific issues

•  The package

•  This time I personally created the

Format of Exam and Review Session
•  Multiple choice and longer problems
•  The exam will be comprehensive but long
problems will come from information
covered after the midterm.
•  The material after the midterm will be
covered in detail with long problems
•  Multiple choice questions based on the
earlier part of the course are included in
the review package

•  Let’s get started!

Chapter 12: Risk, Return and
Capital Budgeting

Chapter 12
•  Beta is a measure of market risk
–  Beta = covariance(A, market)
market standard deviation
–  Beta = correlation(A, market) x stock standard deviation standard deviation of market
–  Portfolio Beta = weighted average of the betas of all the stocks in the portfolio
* The Beta of the market portfolio is always 1

Capital Asset Pricing Model
•  Return = Rf + β( Rm – Rf)
–  Rf is the risk free rate which is the rate of
return on treasury bills
–  Rm - Rf is the market risk premium

•  If you plot the security rate of return
against its Beta you get a security market
•  According to the CAPM, all stocks should fall
on the SML

Project vs. Company Risk
•  The discount rate should reflect the risk
associated with the project:
–  If the risk is the same, use the company cost of
–  If the risk is greater, use a rate greater than the
company cost of capital
–  If there is no risk, use the risk free rate

•  Remember that company you opened in the last
chapter? Congratulations, it’s doing pretty well
•  The stock is now selling for $30, with a Beta of
1.2.The treasury bill rate is 5% and the market rate is
1.  What is the expected return on the stock?
2.  What will the price of the stock be in 1 year if a dividend of $5 is paid?
3.  Your stock is being offered in a portfolio with 60% of your stock and 40% of stock B with a Beta of 1.25

What is the beta of the portfolio
If you want a portfolio with a beta the same as the market, what Beta do you need stock B to have?

Chapter 13:The Weighted Average Cost
of Capital( WACC) and Company Valuation
•  The cost of capital is the next best thing or the opportunity cost

* Calculate using market not book value*
•  The return on bonds is the Yield to Maturity
•  The return on equity can be calculated 2 ways:
1.  The Dividend Discount Model: return = div/price + g
Or just div/price for preferred stock
2. Capital Asset Pricing Model: return= rf + β(rm – rf)

•  The WACC model doesn’t take risk into
•  The WACC can be used to value a business by
calculating the NPC using the WACC to discount.
•  The WACC gives a benchmark for valuing other
–  if risk is the same, use WACC
–  If risk is greater, use rate higher than WACC
–  If risk is lower, use rate lower than WACC

•  Back to your company….
•  RECALL: The market return is 15% and the risk
free rate is 5%. Β is 1.2 and the price of your
stocks is still $20.
•  You have 750 common shares outstanding.
•  You have 100 preferred shares outstanding,
selling for $50 per share with $10 annual
•  You have 20 bonds with a yield to maturity of
4% that mature in 5 years and have a coupon
rate of 10%

•  What is the Weighted Average cost of
•  What interest rate should you use to value a
project with higher...
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