# Paper

**Topics:**Net present value, Internal rate of return, Rate of return

**Pages:**17 (2221 words)

**Published:**September 23, 2014

Review

Taught by: Tana Chasakara

tchasaka@uoguelph.ca

http://guelph.soscampus.com/

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

more

• 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

package

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

Questions?

• 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

line

• 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

capital

– 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

Example

• 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

15%

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)

WACC

• The WACC model doesn’t take risk into

consideration

• 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

stocks;

– 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

Example

• 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

dividends.

• You have 20 bonds with a yield to maturity of

4% that mature in 5 years and have a coupon

rate of 10%

Example

• What is the Weighted Average cost of

capital?

• What interest rate should you use to value a

project with higher...

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