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Flashcards in Financial Planning Concepts Deck (16):

Sharpe measure

Measures portfolio risk that is similar to Treynor index, except the risk measure is the standard deviation of the portfolio, not the beta.

(Portfolio Return - Risk-Free Rate) / Standard Deviation =

Portfolio Return Per Unit of Risk

Standard Deviation - risk after already diversifying your portfolio - client is not too concerned about the volatility in the market.


Treynor index

Measures portfolio risk as Portfolio Return per Unit of Risk:

(Portfolio Return - Risk-Free Rate ) / Beta =

Portfolio Return Per Unit of Risk

Beta = represents market risk/systematic risk/nondiversifiable risk - basically the risk that EVERYONE must face - fluctuations in the individual stock PLUS in the market

Exam tip - if the MCQ says 'portfolio return per unit of risk" and client is concerned about the "volatile market", that is the Treynor Index.


Jensen measure

Measures portfolio risk in the absolute value of the performance of the portfolio on a risk-adjusted basis


Fundamental analysis

Means you believe in the WEAK efficient market hypothesis.

Analyze the business's core numbers: financial ratios, review financial statements and footnotes, level of working capital, level of debt and equity financing, company's level of activities (you are looking at the fundamentals of the issuer's business) = you are looking for the INTRINSIC value in the security to see if it is a good investment. You are looking INSIDE that company's nuts and bolts.

Think: F in Fundamental is for Financial statements



Technical analysis

Means you believe in the STRONG efficient market hypothesis.

Analyze statistics generated by activity on the market, such as historical prices and volume. Use charts and other tools to identify patterns to predict future activity.

Technical analysis does not care about finding intrinsic value. Just wants to guess how the security will behave based on past patterns of behavior on the MARKET. You are looking at the company from the outside and see how it weathers the market conditions. You don't care about what goes on inside the company. Just how it has behaved on the market over the years.




Weak market hypothesis efficiency

Assumes that all historical information (past prices) of a security are captured in today's stock price. (The past is the past, that is it.)

Assumes that technical analysis will NOT help you predict and beat the market.

Focus on Fundamental analysis to find undervalued/overvalued investments by looking at Financial statements.




Strong market efficiency hypothesis

Assumes that you CAN predict and beat the market.

Focuses on Technical analysis to predict the price movement of investments



Degrees of Efficient market hypothesis (EMH) and what is exactly EMH?

Weak, Strong, in between

EMH assumes that there is absolutely no way to beat the market by doing technical or fundamental analyses because the stock prices reflect ALL relevant information. Assumes it is impossible to find an undervalued stock or predict that the sales price of a stock will increase and sell at that price point. Assumes the market is perfectly efficient in giving us all the information we need upfront and there is no other way around it.

Some folks argue that the market efficiency is WEAK and can apply FUNDAMENTAL analysis to find a good deal.

Some folks argue that the market efficiency is STRONG, meaning the information is so strong in the stock prices that we can actually predict the price of the stock by getting TECHNICAL (graphs, charts, statistics).


CAPM Equation - why do we care about it?

Capital Asset Pricing Model (CAPM) helps us compute an entity's Required Rate of Return for Equity = RRRe

Why equity? Capital assets represents equity like owning shares in another company.

CAPM incorporates the entity's portfolio risk to come up with its RRRe

RRRe = Risk Free % + B(LT Avg Risk Premium - Risk Free%)

(B is Beta - the risk of having non-diversified portfolio)

You put the RRRe in the Equity component of the WACC formula (Wt-e + k-e). k-e is Equity Capital's rate of return =

By computing the RRRe for each option, you can compute the WACC for any combination of options and compare. Whoever has the lowest WACC is the winning capital structure.



Weighted Average Cost of Capital = represents the capital structure by weighting the costs of debt and equity financing. Used for evaluating long term projects or investments.

Recall debt and equity financing are costs of raising capital externally.

Helps firms decide whether one capital structure is better than another by comparing WACC respectively. Obviously go with the WACC that is lower than the Rate of Return)

WACC = (wt x k ) + (wt x k ) + (wt x k )
d d pf pf e e

If the exam problem is silent on preferred dividends, simply take it out of the WACC formula. Not all capital structures will have preferred dividends.


How do we treat the weighted average cost of DEBT in the WACC formula?

Interest is tax deductible. Hence, the cost of debt is LESS than the face amount.

K-d (1 - Tx%)

The full WACC computation for the Debt component is really:

Wt x K-d (1 - Tx%)


How is the weighted average cost of PREFERRED DIVIDENDS in the WACC formula computed?

No tax deduction for preferred dividends. Entire preferred dividends is the cost.

K-Pf = Dividends / Price x (1 - Flotation)

Wt x K-Pf


How is the weighted average cost of EQUITY in WACC formula computed?

No tax deduction for equity investments.
Use the Required Rate of Return on Equity as the Cost (RRRe)

Recall CAPM equation for RRRe:

Risk-Free% - B(LT Avg Premium - Risk Free)

K-e = RRRe

Wt x K-e


What is the optimal capitalization for an organization?

The lowest WACC because we want to keep the cost of capital as low as possible. WACC determines the weighted cost of capital coming from debt, preferred stock, and equity. WACC allocates the cost among these three potential sources of capital (funds that can be raised externally to finance the company's projects/activities).


How is the validity of a contract between a corporation and a board director determined?

This is really a question about related-party transaction. The Board Director must disclose the interest to the independent directors of the board AND refrain from voting. This is to ensure that the director does not try to push the company to his or her favor in light of the contract. The contract can only be valid as long as it has been disclosed properly and that the member stays out of the voting process in order to maintain the Board's independence.


Purpose of Business Judgment Rules

Protects directors and officers from being sued by shareholders for lack of due care in discharging the corporation's business.

Officers and directors have a Fiduciary Duty to the corporation and its shareholders

Must act in Good Faith

Act with reasonable care, best judgment, and diligence in good faith

Focus on acting in interests of the corporation and its shareholders, not for their own personal interests

Must be competent in handling these duties

They are NOT liable for losses for errors in judgment so long as they show that they acted in Good Faith, acted in the best interests of the Corporation and shareholders, were competent in handling the duties, gave reasonable care, used best judgment and diligence.