final cheat sheet.docx - A stock has a beta of 1.35 and an...

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Market risk prem=Rm-Rf risk prem is proportional to Beta CAPM & Security Mkt Line R i = R f + β × ( R m – R f ) CAPM=expected stock return=cost of equity E(Rp)=w1r1+w2r2 Bp=w1B1+w2B2 β is calculated using regression analysis: β is sensitivity of a stock’s returns to swings in the market: β i = ( σ im / σ m 2 ) β = 1, the stock’s prices perfectly comove with the market β > 1, the stock’s prices move in the same direction as the market, but more volatile 0 < β < 1, the stock’s prices move in the same direction as the market, but less volatile β < 0, the stock’s prices move in opposite directions with the market B=0=Rf B=1=Rm R = * R Δ β Δ M If trying to find if return can be improved w/o changing risk (w/risk free asset): Use P 2 = x 1 2 1 2 + 2x 1 x 2 1 2 12 + x 2 2 2 2 and set = to given SD Find weights then find new Rp and compare to old Rp (if there is risk free asset find new SD and Rp and compare) Overvalued/under? Use CAPM if CAPM<Rm over CAPM>Rm under Optimal risky portfolio=market portfolio Required rate of return=cost of capital (opportunity)=appropriate discount rate Cost of Equity=R E =(D1/P0)+g using DDM or Use CAPM R E = R f + β E × ( R m – R f ) Cost of Debt is observable: YTM Interest exp on debt is tax deductible so After tax cost=(R D )(1-Tc) WACC=(E/V)(R E )+(D/V)(R D )(1-Tc) R D <R E as D/V increases, cost of equity increases WACC is appropriate discount rate for firms avg risk projects NOT if new projects are more or less risky than the avg If different risk need to calculate new WACC Pure Plays: specialize in one activity Estimate new project risk (B) BUT make sure firm has same leverage as pure play If same then B of pure play = B of project but if not it needs adjustment
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