Chapter 12 - Estimating th Cost of Capital Flashcards
(31 cards)
According to the CAPM, we can determine the cost of capital of an investment by comparing it to what portfolio?
The Market portfolio
What inputs do we need to estimate a firm’s equity cost of capital using the CAPM?
Market portfolio and estimate the beta.
Value Weighted Portfolio
also called an equal-ownership portfolio. It consists of the same fraction of the outstanding shares of each security.
Passive Portfolio
A portfolio that is not rebalanced in response to price changes
Market Index
It is the market value of a broad-based portfolio of securities
Price-Weighted Portfolio
holds an equal number of shares of each stock; size of stock doesn’t matter
Index Funds
Mutual funds that invest in stocks in proportion to their representation in a published index (e.g. S&P 500)
Exchange-traded fund (ETF)
Securities that trade on an exchange that are entirely invested in a portfolio of stocks that represent portfolios such as market indices like the S and P 500
The yield to maturity of a bond
is the IRR an investor will earn from holding the bond to maturity and receiving its promised payments.
If there is little risk of the firm defaulting then yield to maturity can estimate the investor’s expected return.
If there is a risk of the firm defaulting, then the yield to maturity of the firm’s debt, it’s promised return will overstate investor’s expected return.
What is a market proxy?
A portfolio whose return they believe closely tracks the true market value.
How do you determine the weight of the stock in the market portfolio?
By using the market index
How do we define a stock’s alpha, and what is its interpretation?
The difference between a security’s expected return, and its CAPM required return, from the security market line. According to the CAPM, all stocks and securities should be on the security market line and have an alpha of zero. If some securities have a nonzero alpha, the market portfolio is not efficient, and its performance can be improved by buying securities
with positive alphas and selling those with negative alphas.
How can you estimate a stock’s beta from historical returns?
Through the best-fitting line.
It is common to estimate a stock’s beta based on the historical correlation and volatilities. Makes sense to do so if the beta is stable over a period of time.
All equity financed firm
a firm with no debt
2 drawbacks for looking at the historical risk premium
- Despite having at least 50 years of data, the standard errors of the estimates are large
- Because you’re looking back through history, you can’t be sure that the estimates correctly estimate the current expectations
Examples of Market Indexes
- S and P 500 (value-weighted)
2. Dow Jones Industrial Average (price-weighted)
How can you estimate market risk premium?
Historical Data (i.le. stock market index)
Survey
Implied Rates
How do we define a stock’s alpha, and what is its interpretation?
It is the distance the stock’s average return is above or below the SML
Debt Cost of Capital
cost of capital that a firm must pay on its debt
Asset cost of capital (or unlevered cost of capital)
expected return required by the firm’s investors to hold the firm’s underlying assets, is the weighted average of the firm’s equity and debt costs of capital
Levered Firms as Comparables
This is for when the firm has a debt.
All equity comparables
This is for when the firm has no debt.
Enterprise value
combined market value of the firm’s equity and debt, less any excess cash.
True or False
Asset (unlevered) cost of capital does not have any leverage
False
It is called this because the return on assets is the same as the return on equity if the firm would have no leverage