## Info

Uncommitted lines of credit are, as the name suggests, the weakest form of bank borrowing. A bank may offer an uncommitted line of credit for an extended period of time, but it reserves the right to refuse to honor any request for use of the line. In other words, an uncommitted line is very unstable and is only as good as the bank's desire to offer it. Therefore, companies should not rely very much on uncommitted lines. In fact, banks will not officially acknowledge that an uncommitted line is...

## Numerous Portfolio Combinations of Available Assets

Up of portfolios of investments rather than individual securities. Two possible exceptions arise at the end points, which represent the asset with the highest return and the asset with the lowest risk. As an investor, you will target a point along the efficient frontier based on your utility function, which reflects your attitude toward risk. No portfolio on the efficient frontier can dominate any other portfolio on the efficient frontier. All of these portfolios have different return and risk...

## Summary

In this reading, we considered a key aspect of financial management the management of a company's working capital. This aspect of finance is a critical one in that it ensures, if done effectively, that the company will stay solvent and remain in business. If done improperly, the results can be disastrous for the company. Working capital management covers a wide range of activities, most of which are focused on or involve the company's cash levels. Competing uses for the company's cash, which is...

## Relationship Between Systematic Risk And Return

The ultimate question regarding the GAPM is whether it is useful in explaining the return on risky assets. Specifically, is there a positive linear relationship between the systematic risk and the rates of return on these risky assets Sharpe and Cooper (1972b) found a positive relationship between return and risk, although it was not completely linear. Because of the statistical problems with individual stocks, Black, Jensen, and Scholes (1972) examined the risk and return for portfolios of...

## Exhibit 6

Is Over But Not Over This Amount Plus This Of the Excess Over 7,150 29,050 70,350 146,750 319,100 0 14,300 58,100 117,250 178,650 319,100 7,150 29,050 70,350 146,750 319,100 > 14,300 58,100 117,250 178,650 319,100 715 4,000 14,325 35,717 92,592 0 1,430 8,000 22,787 39,979 86,328 15 25 28 33 35 10 15 25 28 33 35 7,150 29,050 70,350 146,750 319,100 0 4,300 8,600 117,250 178,650 319,100 Note For updates, go to the 1RS website, www.irs.gov. The average tax rate is simply a person's total tax...

## Example

Estimating the Equity Risk Premium Using Historical Rates of Return Suppose that the arithmetic average T-bond rate observed over the last 100 years is an unbiased estimator for the risk-free rate and amounts to 5.4 percent. Likewise, suppose the arithmetic average of return on the market observed over the last 100 years is an unbiased estimator for the expected return for the market. The average rate of return of the market was 9.3 percent. Calculate the equity risk premium. Solution ERP RM Rf...

## Investments Online

Asset pricing models show how risk measures or underlying return-generating factors will affect asset returns. Estimates from such models are usually proprietary and are available from providers only by buying their research. Of course, users can always purchase their raw data elsewhere (see some of our earlier internet discussions) and develop their own estimates of beta and factor sensitivities. www.valueline.com The Value Line Investment Survey has been a long-time favorite of investors and...

## C J X

0 8.06 12.85 Risk (Standard deviation) The negative correlation coefficient reduces risk without sacrificing return. (*port) ('6 X -10) + (-4 X -15) -12 CTpon V(.6)2(.03)2 + (.4)2(.05)2 + 2(.6) (.4) (.03) (.05) (n,2) V.000324 + .0004 + .00072 (r1> 2) V.000724 + .00072 (r1> 2) A. V.000724 + .00072(1.0) V.001444 .0380 B. V.000724 + .00072 (.75) V.001264 .0356 C. V.000724 + .00072 (.25) V.000904 .0301 D. V.000724 + .00072 (.00) V.000724 .0269 E. V.000724 + .00072 (-.25) V.000544 .0233 F....

## The Market Portfolio

Because Portfolio M lies at the point of tangency, it has the highest portfolio possibility line, and everybody will want to invest in Portfolio M and borrow or lend to be somewhere on the CML. This portfolio must, therefore, include all risky assets. If a risky asset were not in this portfolio in which everyone wants to invest, there would be no demand for it and therefore it would have no value. Because the market is in equilibrium, it is also necessary that all assets are included in this...

## Management

While the Board helps set the strategic, ethical and financial course for a Company in consultation with management, Investors ultimately must rely on management to implement that course. Management also has the responsibility to communicate to Investors and the public about the Company's performance, financial condition and any changes in strategy or corporate initiatives in an effective and timely manner. Investors are familiar with the reports that management issues with regard to a...

## Investing Shortterm Funds

Short-term investments represent a temporary store of funds that are not necessarily needed in a company's daily transactions. If a substantial portion of a company's working capital portfolio is not needed for short-term transactions, it should be separated from a working capital portfolio and placed in a longer-term portfolio. Such longer-term portfolios are often handled by another area or are handled by an outside money manager under the company's supervision. In this way, the risks,...

## Exhibit 1

1 American Management Association, Executive Committee Control Charts, AMA Management Bulletin, no. 6 (1960) 22. This system is consistent with the logic set forth by Alfred Marshall in his Elements of Economics of Industry (MacMillan and Co., 1892), book 2, chapter 12, sections 3 and 4. 2 An easy way to remember the DuPont system is to keep in mind that cross-cancellation of terms produces the desired return. For example, Net income Net income Revenues Average total assets Revenues Average...

## Net

Exhibit 8 summarizes the relationship between the required rate of return for each stock based on its systematic risk as computed earlier, and its estimated rate of return (from Exhibit 7) based on the current and future prices, and its dividend outlook. This difference between estimated return and expected (required) return is sometimes referred to as a stock's alpha or its excess return. This alpha can be positive (the stock is undervalued) or negative (the stock is overvalued). If the alpha...

## Rfr

Potential combinations dominate all portfolio possibilities on the original efficient frontier below Point B (including Line RFR-A). You can draw further lines from the RFR to the efficient frontier at higher and higher points until you reach the point where the line is tangent to the frontier, which occurs in Exhibit 1 at Point M. The set of portfolio possibilities along Line RFR-M dominates all portfolios below Point M. For example, you could attain a risk and return combination between the...

## Exhibit 9

Sales-Driven Accounts for Wal-Mart Stores, 90 -, 80 -70 -60 -Percent 50 -of sales 40 -30 -20 -10 0 Panel A. Sales-Driven Income Statement Accounts l Cost of sales as a percent of sales i Operating expenses as a percent of sales l Cost of sales as a percent of sales i Operating expenses as a percent of sales 90 -, 80 -70 -60 -Percent 50 -of sales 40 -30 -20 -10 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Fiscal year ending 31 January 1991 1992 1993 1994 1995 1996...

## The Capital Asset Pricing Model Expected Return And Risk

Up to this point, we have considered how investors make their portfolio decisions, including the significant effects of a risk-free asset. The existence of this risk-free asset resulted in the derivation of a capital market line (CML) that became the relevant efficient frontier. Because all investors want to be on the CML, an asset's covariance with the market portfolio of risky assets emerged as the relevant risk measure. Now that we understand this relevant measure of risk, we can proceed to...

## Vivid Booknet

If we examined different two-asset combinations and derived the curves assuming all the possible weights, we would have a graph like that in Exhibit 14. The envelope curve that contains the best of all these possible combinations is referred to as the efficient frontier. Specifically, the efficient frontier represents that set of portfolios that has the maximum rate of return for every given level of risk or the minimum risk for every level of return. An example of such a frontier is shown in...

## Capital Market Theory An Overview

Because capital market theory builds on portfolio theory, this reading begins where the discussion of the Markowitz efficient frontier ended. We assume that you have examined the set of risky assets and derived the aggregate efficient frontier. Further, we assume that you and all other investors want to maximize your utility in terms of risk and return, so you will choose portfolios of risky assets on the efficient frontier at points where your utility maps are tangent to the frontier as shown...

## Wacc

0.5 2.5 4.5 6.5 8.5 10.5 12.5 14.5 16.5 18.5 38 Later in this section, we will discuss cases where a company's WACC may actually decrease as additional capital is raised. For example, if a company financed solely with common equity raises additional capital via debt, then the tax advantages provided by debt will result in a lower WACC under the new capital structure. For this discussion, we are assuming that the company is already operating at or near its optimum balance of debt versus equity....

## Box

In assisting an investor in the policy statement process, an advisor should ensure that the policy statement satisfactorily answers the following questions 1. Is the policy carefully designed to meet the specific needs and objectives of this particular investor (Cookie-cutter or one-size-fits-all policy statements are generally inappropriate.) 2. Is the policy written so clearly and explicitly that a competent stranger could manage the portfolio in conformance with the client's needs in case of...

## Practice Problems For Reading

Cumulative voting is best described as A. a mechanism for suppressing hostile takeovers. B. a means of offsetting the negative consequences of super-voting rights shares. C. enhancing the likelihood that shareowners' interests are represented on the Board. 2. Which of the following is least consistent with good corporate governance A. Allowing shareowners the right to vote their shares by proxy. B. Ensuring that a majority of the members of the audit committee are independent members of the...

## Solutions For Reading

Current ratio Current assets Current Liabilities Current assets 100 million 2.5 Therefore, current assets 250 million Quick ratio (Current assets Inventory) Current Liabilities ( 250 million - Inventory) 100 million 1.5 Therefore, Inventory 100 million Number of days of inventory 2,300 ( 20,000 365) 41.975 days Number of days of receivables 2,500 ( 25,000 365) 36.5 days Operating cycle 41.975 + 36.5 days 78.475 days Note The net operating cycle is 47.9 days. Purchases 20,000 + 2,300 - 2,000...

## The Board

Board Members owe a duty to make decisions based on what ultimately is best for the long-term interests of Shareowners. In order to do this effectively, Board Members need a combination of three things Independence, experience and resources. First, a Board should be composed of at least a majority of Independent Board Members with the autonomy to act Independently from management. Board Members should bring with them a commitment to take an unbiased approach in making decisions that will...

## Some Background Assumptions

Before presenting portfolio theory, we need to clarify some general assumptions of the theory. This includes not only what we mean by an optimum portfolio but also what we mean by the terms risk aversion and risk. One basic assumption of portfolio theory is that as an investor you want to maximize the returns from your total set of investments for a given level of risk. To adequately deal with such an assumption, certain ground rules must be laid. First, your portfolio should include all of...

## Defining Liquidity Management

Liquidity management refers to the ability of an organization to generate cash when and where it is needed. Liquidity refers to the resources available for an entity to tap into cash balances and to convert other assets or extend other liabilities into cash for use in keeping the entity solvent (i.e., being able to pay bills and continue in operation). For the most part, we associate liquidity with short-term assets and liabilities, yet longer-term assets can be converted into cash to provide...

## The Market Portfolio Theory Versus Practice

Throughout our presentation of the CAPM, we noted that the market portfolio included all the risky assets in the economy. Further, in equilibrium, the various assets would be included in the portfolio in proportion to their market value. Therefore, this market portfolio should contain not only U.S. stocks and bonds but also real estate, options, art, stamps, coins, foreign stocks and bonds, and so on, with weights equal to their relative market value. Although this concept of a market portfolio...

## Empirical Tests Of The Capm

When we discussed the assumptions of capital market theory, we pointed out that a theory should not be judged on the basis of its assumptions, but on how well it explains the relationships that exist in the real world. When testing the CAPM, there are two major questions. First, How stable is the measure of systematic risk (beta) Because beta is our principal risk measure, it is important to know whether past betas can be used as estimates of future betas. Also, how do the alternative published...

## Dupont Analysis

DuPont analysis was developed by E.I. du Pont de Nemours and Co. in 1919 as a way to better understand return ratios and why they change over time.1 The bases for this approach are the linkages made through financial ratios between the balance sheet and the income statement. We can better understand a company's returns over time or its returns in comparison with its competitors by breaking returns into their components. This approach began as an analysis of the elements in the return on assets....

## Reading Assignments

Reading 49 The Asset Allocation Decision Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly, CFA and Keith C. Brown, CFA Reading 50 An Introduction to Portfolio Management Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly, CFA and Keith C. Brown, CFA Reading 51 An Introduction to Asset Pricing Models Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly, CFA and Keith C. Brown, CFA

## Cost of Common Equity

The cost of common equity, (r), usually referred to simply as the cost of equity, is the rate of return required by a company's common shareholders. A company may increase common equity through the reinvestment of earnings that is, retained earnings or through the issuance of new shares of stock. As we discussed earlier, the estimation of the cost of equity is challenging because of the uncertain nature of the future cash flows in terms of the amount and timing. Commonly used approaches for...

## Zero Beta Model

If the market portfolio (M) is mean-variance efficient (i.e., it has the lowest risk for a given level of return among the attainable set of portfolios), an alternative model, derived by Black (1972), does not require a risk-free asset. Specifically, within the set of feasible alternative portfolios, several portfolios exist where the returns are completely uncorrelated with the market portfolio the beta of these portfolios with the market portfolio is zero. From among the several zero-beta...

## W M

A. describe the steps in the portfolio management process and explain j the reasons for a policy statement b. explain why investment objectives should be expressed in terms of risk and return and list the factors that may affect an investor's risk tolerance j ma Bm c. describe the return objectives of capital preservation, capital i appreciation, current income, and total return I d. describe the investment constraints of liquidity, time horizon, tax . . , , . --- Although this reading e....

## Qph

A. explain the capital market theory, including its underlying assumptions, and explain the effect on expected returns, the standard deviation of returns, and possible risk-return combinations when a risk-free asset is combined with a portfolio of risky assets j b. identify the market portfolio and describe the role of the market portfolio in the formation of the capital market line (CML) c. define systematic and unsystematic risk and explain why an investor should not expect to receive...

## Managing Inventory

The primary goal for an inventory system is to maintain the level of inventory so that production management and sales management can make and sell the company's products without more than necessary invested in this asset. Like cash and accounts receivable management, inventory management involves balancing having sufficient inventory, but not too much. Inventory is a current asset that is created by purchasing, paid by accounts payable, and funded by the treasury. The investment in inventory...

## Standard Deviation of a Portfolio

As noted, a correlation of +1.0 indicates perfect positive correlation, and a value of 1.0 means that the returns moved in completely opposite directions. A value of zero means that the returns had no linear relationship, that is, they were uncorrelated statistically. That does not mean that they are independent. The value of r. 0.109 is not significantly different from zero. This insignificant positive correlation is not unusual for stocks versus bonds during short time intervals such as one...

## Discounted Payback Period

The discounted payback period is the number of years it takes for the cumulative discounted cash flows from a project to equal the original investment. The discounted payback period partially addresses the weaknesses of the payback period. Table 4 gives an example of calculating the payback period and discounted payback period. The example assumes a discount rate of 10 percent. TABLE 4 Payback Period and Discounted Payback Period TABLE 4 Payback Period and Discounted Payback Period

## Gsh

Exhibit 23 contains the average RFR, the market returns, and the slope of the SML during three time periods for the two indexes. Clearly, the slopes differ dramatically among the alternative indexes and over time. Needless to say, the benchmark used does make a difference. In summary, an incorrect market proxy will affect both the beta risk measures and the position and slope of the SML that is used to evaluate portfolio performance. In general, the errors will tend to overestimate the...

## The Security Market Line SML

We know that the relevant risk measure for an individual risky asset is its covariance with the market portfolio (Cov.M). Therefore, we can draw the risk-return relationship as shown in Exhibit 5 with the systematic covariance variable (CovfM) as the risk measure. The return for the market portfolio (Rshould be consistent with its own risk, which is the covariance of the market with itself. If you recall the formula for covariance, you will see that the covariance of any asset with itself is...

## Effect of Skewness on the Relationship

Beyond the analysis of return and beta, several authors also have considered the impact of skewness on expected returns. You will recall from your statistics course that skewness reflects the presence of too many large positive or negative observations in a distribution. A normal distribution is symmetric, which means that balance exists between positive and negative observations. In contrast, positive skewness indicates an abnormal number of large positive price changes. Investigators...

## WwwVivia Booknet

Credit accounts vary by type of customer and the industry, and granting credit involves a tradeoff between increasing sales and uncollectible accounts. There are three primary activities in accounts receivable management granting credit and processing transactions, monitoring credit balances, and measuring performance of the credit function. Processing accounts receivable transactions requires recording credit sales to create a record and posting customer payments or at least monitoring the...

## Number of Stocks in a Portfolio and the Standard Deviation of Portfolio Return

Standard Deviation of the Market Portfolio (Systematic Risk) 2 The discussion in the reading introducing portfolio management leads one to conclude that securities with negative correlation would be ideal. Although this is true in theory, it is difficult to find such assets in the real world. concluded that a well-diversified stock portfolio must include at least 30 stocks for a borrowing investor and 40 stocks for a lending investor. An important point to remember is that, by adding stocks to...

## Introduction

A company grows by making investments that are expected to increase revenues and profits. The company acquires the capital or funds necessary to make such investments by borrowing or using funds from owners. By applying this capital to investments with long-term benefits, the company is producing value today. But, how much value The answer depends not only on the investments' expected future cash flows but also on the cost of the funds. Borrowing is not costless. Neither is using owners' funds....

## Weights of the Weighted Average

How do we determine what weights to use Ideally, we want to use the proportion of each source of capital that the company would use in the project or company. If we assume that a company has a target capital structure and raises capital consistent with this target, we should use this target capital structure. The target capital structure is the capital structure that a company is striving to obtain. If we know the company's target capital structure, then, of course, we should use this in our...

## Study Session

This study session covers the principles that corporations use to make their investing and financing decisions. Capital budgeting is the process of making decisions about which long-term projects the corporation should accept for investment and which it should reject. Both the expected return of a project and the financing cost should be taken into account. The cost of capital, or the rate of return required for a project, must be developed using economically sound methods. Corporate managers...

## Exhibit

You've heard the expression no pain, no gain In the investment world, the comparable phrase would be no risk, no reward. How you feel about risking your money will drive many of your investment decisions. The risk-comfort scale extends from very conservative (you don't want to risk losing a penny regardless of how little your money earns) to very aggressive (you're willing to risk much of your money for the possibility that it will grow tremendously). As you might guess, most investors'...

## Feedback

At CFA Institute, we are committed to delivering a comprehensive and rigorous curriculum for the development of competent, ethically grounded investment professionals. We rely on candidate and member feedback as we work to incorporate content, design, and packaging improvements. You can be assured that we will continue to listen to your suggestions. Please send any comments or feedback to curriculum cfainstitute.org. Ongoing improvements in the curriculum will help you prepare for success on...

## Effect of Size PE and Leverage

In the efficient markets hypothesis (EMH) reading, we discussed the size effect (the small-firm anomaly) and the P E effect and showed that these variables have an inverse impact on returns after considering the CAPM. These results imply that size and P E are additional risk factors that need to be considered along with beta. Specifically, expected returns are a positive function of beta, but investors also require higher returns from relatively small firms and for stocks with relatively low P...

## Cm Cm Cm Cm

Source Wal-Mart Stores, Inc., 10-K filings, various years. Comparing Wal-Mart with Target Inc. and Kohl's in the 2005 fiscal year, as shown in Exhibit 3, we see differences among these three competitors. These differences may be explained, in part, by the different product mixes (e.g., Wal-Mart has more sales from grocery lines than the others), as well as different inventory management systems and different inventory suppliers. The different need for liquidity may also be explained, in part,...

## Variance Standard Deviation of Returns for a Portfolio

Two basic concepts in statistics, covariance and correlation, must be understood before we discuss the formula for the variance of the rate of return for a portfolio. Covariance of Returns In this subsection we discuss what the covariance of returns is intended to measure, give the formula for computing it, and present an example of its computation. Covariance is a measure of the degree to which two variables move together relative to their individual mean values over time. In portfolio...

## Learning Outcomes

The candidate should be able to a. define and describe corporate governance b. discuss and critique characteristics and practices related to board and committee independence, experience, compensation, external consultants, and frequency of elections, and determine whether they are supportive of shareowner protection c. describe board independence and explain the importance of independent board members in corporate governance d. identify factors that indicate a board and its members possess the...

## Background for Capital Market Theory

When dealing with any theory in science, economics, or finance, it is necessary to articulate a set of assumptions that specify how the world is expected to act. This allows the theoretician to concentrate on developing a theory that explains how some facet of the world will respond to changes in the environment. In this section, we consider the main assumptions that underlie the development of capital market theory. Assumptions of Capital Market Theory Because capital market theory builds on...

## Npv

The capital budgeting decision rules are to invest if the NPV > 0, if the IRR > r, or if the PI > 1.0 There are no decision rules for the payback period, discounted payback period, and AAR because they are not always sound measures. The NPV profile is a graph that shows a project's NPV graphed as a function of various discount rates. For mutually exclusive projects that are ranked differently by the NPV and IRR, it is economically sound to choose the project with the higher NPV. The...

## Estimating the Proportions of Capital

Fin Anziell is a financial analyst with Analytiker Firma. Anziell is in the process of estimating the cost of capital of Gewicht GmbH. The following information is provided Market value of debt 50 million Market value of equity 60 million Primary competitors and their capital structures (in millions)

## Glossary

A priori probability A probability based on logical analysis rather than on observation or personal judgment. Abandonment option The ability to terminate a project at some future time if the financial results are disappointing. Abnormal rate of return The amount by which a security's actual return differs from its expected rate of return which is based on the market's rate of return and the security's relationship with the market. Above full-employment equilibrium A macroeco-nomic equilibrium...

## H

Assume that ABC Corporation has the following capital structure 30 percent debt, 10 percent preferred stock, and 60 percent equity. ABC Corporation wishes to maintain these proportions as it raises new funds. Its before-tax cost of debt is 8 percent, its cost of preferred stock is 10 percent, and its cost of equity is 15 percent. If the company's marginal tax rate is 40 percent, what is ABC's weighted average cost of capital Solution The weighed average cost of capital is WACC (0.3)(0.08)(1 -...

## Www

In this reading, we saw that investors need to prudently manage risk within the context of their investment goals and preferences. Income, spending, and investing behavior will change over a person's lifetime. We reviewed the importance of developing an investment policy statement before implementing a serious investment plan. By forcing investors to examine their needs, risk tolerance, and familiarity with the capital markets, policy statements help investors correctly identify appropriate...

## Input To The Policy Statement

Before an investor and advisor can construct a policy statement, they need to have an open and frank exchange of information, ideas, fears, and goals. To build a framework for this information-gathering process, the client and advisor need to discuss the client's investment objectives and constraints. To illustrate this framework, we discuss the investment objectives and constraints that may confront typical 25-year-old and 65-year-old investors. The investor's objectives are his or her...

## Level I 2010

Corporate Finance and Portfolio Management New York Boston San Francisco London Toronto Sydney Tokyo Singapore Madrid Mexico City Munich Paris Cape Town Hong Kong Montreal Cover Art Courtesy of Alejandro Bolivar Corbis. Copyright 2010,2009,2008,2007,2006 by CFA Institute All rights reserved. This copyright covers material written expressly for this volume by the editor s as well as the compilation itself. It does not cover the individual selections herein that first appeared elsewhere....

## The Importance Of Asset Allocation

A m< yor reason why investors develop policy statements is to determine an overall investment strategy. Though a policy statement does not indicate which specific securities to purchase and when they should be sold, it should provide guidelines as to the asset classes to include and the relative proportions of the investor's funds to invest in each class. How the investor divides funds into different asset classes is the process of asset allocation. Rather than present strict percentages,...

## Constructing The Policy Statement

As we have seen, the policy statement allows the investor to communicate his or her objectives (risk and return) and constraints (liquidity, time horizon, tax, legal and regulatory, and unique needs and preferences). This communication gives the advisor a better chance of implementing an investment strategy that will satisfy the investor. Even if an advisor is not used, each investor needs to take this first important step of the investment process and develop a financial plan to guide the...

## Example of a PI Calculation

The Gerhardt Corporation investment (discussed earlier) had an outlay of 50 million, a present value of future cash flows of 63.136 million, . XTrar r i o no > MI- mi r- i i and an NPV of 13.136 million. The profitability index is _ PV of future cash flows _ 63.136 _ Because the PI > 1.0, this is a profitable investment. _

## Comparability of Published Estimates of Beta

In contrast to deriving your own estimate of beta for a stock, you may want to use a published source for speed or convenience, such as Merrill Lynch's Security Risk Evaluation Report (published monthly) and the weekly Value Line Survey. Both services use the following market model equation Notably, they differ in the data used. Specifically, Merrill Lynch uses 60 monthly observations and the S& P 500 as the market proxy, whereas the Value Line estimates beta using 260 weekly observations...

## C

An analyst gathered the following information about a company and the market Current market price per share of common stock 28.00 Most recent dividend per share paid on common stock (D0) 2.00 Expected dividend payout rate 40 Expected return on equity (ROE) 15 Expected rate of return on the market portfolio 13 Using the Capital Asset Pricing Model (CAPM) approach, the cost of retained earnings for the company is closest to A. 13-6 . 26. An analyst gathered the following information about a...

## Organization

The Level I CFA Program curriculum is organized into 10 topic areas. Each topic area begins with a brief statement of the material and the depth of knowledge expected. Each topic area is then divided into one or more study sessions. These study sessions 18 sessions in the Level I curriculum should form the basic structure of your reading and preparation. Each study session includes a statement of its structure and objective, and is further divided into specific reading assignments. The outline...

## WwwVivid Booknet

Utility is at Point X in Exhibit 16, where the U2 curve just touches the efficient frontier. A less risk-averse investor's highest utility occurs at Point Y, which represents a portfolio on the efficient frontier with higher expected returns and higher risk than the portfolio at X. utility is at Point X in Exhibit 16, where the U2 curve just touches the efficient frontier. A less risk-averse investor's highest utility occurs at Point Y, which represents a portfolio on the efficient frontier...

## Stability of Beta

Numerous studies have examined the stability of beta and generally concluded that the risk measure was not stable for individual stocks, but the stability of the beta for portfolios of stocks increased dramatically. Further, the larger the portfolio of stocks (e.g., over 50 stocks) and the longer the period (over 26 weeks), the more stable the beta of the portfolio. Also, the betas tended to regress toward the mean. Specifically, high-beta portfolios tended to decline over time toward unity...

## Summary of CAPM Risk Return Empirical Results

Most of the early evidence regarding the relationship between rates of return and systematic risk of portfolios supported the CAPM there was evidence that the intercepts were generally higher than implied by the RFR that prevailed, which is either consistent with a zero-beta model or the existence of higher borrowing Average Slopes t-Statistics from Month-by-Month Regressions of Stock Returns on 0, Size, Book-to-Market Equity, Leverage, and E P July 1963 to December 1990 Stocks are assigned the...

## Individual Investor Life Cycle

Financial plans and investment needs are as different as each individual. Investment needs change over a person's life cycle. How individuals structure their financial plan should be related to their age, financial status, future plans, risk aversion characteristics, and needs. Before embarking on an investment program, we need to make sure other needs are satisfied. No serious investment plan should be started until a potential investor has adequate income to cover living expenses and has a...

## Cost Of Capital

The cost of capital is the rate of return that the suppliers of capital bondholders and owners require as compensation for their contribution of capital. Another way of looking at the cost of capital is that it is the opportunity cost of funds for the suppliers of capital A potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk. A company typically has several...

## Markowitz Portfolio Theory

In the early 1960s, the investment community talked about risk, but there was no specific measure for the term. To build a portfolio model, however, investors had to quantify their risk variable. The basic portfolio model was developed by Harry Markowitz 1952, 1959 , who derived the expected rate of return for a portfolio of assets and an expected risk measure. Markowitz showed that the variance of the rate of return was a meaningful measure of portfolio risk under a reasonable set of...

## Internal Rate of Return

The internal rate of return IRR is one of the most frequently used concepts in capital budgeting and in security analysis. The IRR definition is one that all analysts know by heart. For a project with one investment outlay, made initially, the 1 Occasionally, you will notice some rounding errors in our examples. In this case, the present values of the cash flows, as rounded, add up to 63.135. Without rounding, they add up to 63.13627, or 63.136. We will usually report the more accurate result,...

## Managing And Measuring Liquidity

Liquidity is the extent to which a company is able to meet its short-term obligations using assets that can be readily transformed into cash. When we evaluate the liquidity of an asset, we focus on two dimensions the type of asset and the speed at which the asset can be converted to cash, either by sale or financing. Unlike many aspects of corporate finance, corporate liquidity management does not involve a great deal of theory or generally accepted principles. For companies that have the...

## Measuring Liquidity

Liquidity contributes to a company's credit worthiness. Credit worthiness is the perceived ability of the borrower to pay what is owed on the borrowing in a timely manner and represents the ability of a company to withstand adverse 1 In a recent survey of CFOs, companies have become more efficient in working capital management, with U.S. companies in 2005 reducing their investment in working capital by 2.5 percent from 2004 levels and European companies reducing their investment by 3.3 percent...

## Taxes and the Cost of Capital

Notice that in Equation 1 we adjust the expected before-tax cost on new debt financing, rd, by a factor of 1 t . In the United States and many other tax jurisdictions, the interest on debt financing is a deduction to arrive at taxable income. Taking the tax-deductibility of interest as the base case, we adjust the pre-tax cost of debt for this tax shield. Multiplying rd by 1 t results in an estimate of the after-tax cost of debt. For example, suppose a company pays 1 million in interest on its...

## Summary Corporate Governance Considerations

determine whether a Company's Board has, at a minimum, a majority of Independent Board Members. determine whether Board Members have the qualifications the Company needs for the challenges it faces. determine whether the Board and its committees have budgetary authority to hire Independent third-party consultants without having to receive approval from management. determine whether Board Members are elected annually, or whether the Company has adopted an election process that staggers the...

## Vic

The Gearing Company has an after-tax cost of debt capital of 4 percent, a cost of preferred stock of 8 percent, a cost of equity capital of 10 percent, and a weighted average cost of capital of 7 percent. Gearing intends to maintain its current capital structure as it raises additional capital. In making its capital-budgeting decisions for the average-risk project, the relevant cost of capital is 9. Fran McClure of Alba Advisers is estimating the cost of capital of Frontier Corporation as...

## The following information relates to Questions 1922 The Level I exam uses only independent questions This minicase is

Boris Duarte, CFA, covers initial public offerings for Zellweger Analytics, an independent research firm specializing in global small-cap equities. He has been asked to evaluate the upcoming new issue of TagOn, a U.S.-based business intelligence software company. The industry has grown at 26 percent per year for the previous three years. Large companies dominate the market, but sizable pure-play companies such as Relevant, Ltd., ABJ, Inc., and Opus Software Pvt. Ltd also compete. Each of these...

## Trumpit Resorts Company Currently Has 1.2 Million

The weights that McClure should apply in estimating Frontier's cost of capital for debt and equity are, respectively 10. Wang Securities had a long-term stable debt-to-equity ratio of 0.65. Recent bank borrowing for expansion into South America raised the ratio to 0.75. The increased leverage has what effect on the asset beta and equity beta of the company A. The asset beta and the equity beta will both rise. B. The asset beta will remain the same and the equity beta will rise. C. The asset...

## Pro Forma Analysis

We use common-size statements and financial ratios to gauge the company's financial condition and performance over recent fiscal periods. These analyses are useful in the assessment of what the company has done in the past and what trends and patterns may continue into the future. We can get an even stronger sense of a company's future by constructing pro forma statements, based both on relationships that existed in the recent past and on anticipated events and changes.4 Pro forma statements...

## Marginal Cost of Capital Schedule

As we noted in Section 2.3, as a company raises more funds, the costs of the different sources of capital may change, resulting in a change in the weighted average cost of capital for different levels of financing. The result is the marginal cost of capital MCC schedule, which we often depict in graphical form as the 37 Claude Erb, Campbell R. Harvey, and Tadas Viskanta, Expected Returns and Volatility in 135 CountriesJournal of Portfolio Management Spring 1996 , pp. 46-58. weighted average...

## Monitoring Cash Uses and Levels

Another facet of cash forecasting is monitoring and control. Managing the cash position essentially means keeping a running score on daily cash flows. Monitoring daily cash flows is a key aspect of a company's cash forecasting system in that the financial manager in charge of managing the cash position must know the company's cash balance in the bank on virtually a real-time basis. However, it really is not forecasting as such, because most of the transactions are actually known the challenge...

## Managing Accounts Receivable

The goals for the accounts receivable management system include the following efficient processing and maintaining accurate, up-to-date records that are available to credit managers and other interested parties as soon as possible after payments have been received control of accounts receivable and ensuring that accounts receivable records are current and that no unauthorized entry into the accounts receivable file has occurred collection on accounts and coordination with the treasury...

## Cost of Debt

The cost of debt is the cost of debt financing to a company when it issues a bond or takes out a bank loan. We discuss two methods to estimate the before-tax cost of debt, rd the yield-to-maturity approach and debt-rating approach. The yield to maturity YTM is the annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. In other words, it is the yield, rd, that equates the present value of the bond's promised payments to its market...

## Cost of Preferred Stock

The cost of preferred stock is the cost that a company has committed to pay preferred stockholders as a preferred dividend when it issues preferred stock. In the case of nonconvertible, noncallable preferred stock that has a fixed dividend rate and no maturity date fixed rate perpetual preferred stock , we can use the formula for the value of a preferred stock Pp the current preferred stock price per share Dp the preferred stock dividend per share rp the cost of preferred stock We can rearrange...

## What Do CFOs Do

In this reading, we have introduced you to methods that may be used to estimate the cost of capital for a company or a project. What do companies actually use when making investment decisions In a survey of a large number of U.S. company CFOs, John Graham and Campbell Harvey asked about the methods that companies actually use.43 Their survey revealed the following The most popular method for estimating the cost of equity is the capital asset pricing model. Few companies use the dividend cash...

## Profitability Index

The profitability index PI is the present value of a project's future cash flows divided by the initial investment. It can be expressed as Initial investment Initial investment You can see that the PI is closely related to the NPV. The PI is the ratio of the PV of future cash flows to the initial investment, whereas an NPV is the difference between the PV of future cash flows and the initial investment. Whenever the NPV is positive, the PI will be greater than 1.0 conversely, whenever the NPV...

## D

It is often the case that country and foreign exchange risk are diversified so that we can use the estimated 3 in the CAPM analysis. However, in the case in which these risks cannot be diversified away, we can adjust our measure of systematic risk by a country equity premium to reflect this nondiversified risk Annualized standard deviation of equity index Annualized standard deviation of the sovereign bond market in terms of the developed market currency The dividend discount model approach is...

## In His Estimation Of The Project S Cost Of Capital Sandell Would Like To Use The Asset Beta Of Kruspa As A Base In His

9.25 percent 1.88 percent 37.5 percent Level 15. In his estimation of the project's cost of capital, Sandell would like to use the asset beta of Kruspa as a base in his calculations. The estimated asset beta of Kruspa prior to the China project is closest to 16. Sandell is performing a sensitivity analysis of the effect of the new project on the company's cost of capital. If the China project has the same asset risk as Kruspa, the estimated project beta for the China project, if it is financed...

## Country Risk

The use of a stock's beta to capture the country risks of a project is well supported in empirical studies that examine developed nations. However, beta does not appear to adequately capture country risk for companies in developing nations.33 A common approach for dealing with this problem is to adjust the cost of equity estimated using the CAPM by adding a country spread to the market risk premium.34 The country spread is also referred to as a country equity premium. Perhaps the simplest...

## C 3686

As part of the sensitivity analysis of the effect of the new project on the company's cost of capital, Sandell is estimating the cost of equity of the China project considering that the China project requires a country equity premium to capture the risk of the project. The cost of equity for the project in this case is closest to 18. In his report, Sandell would like to discuss the sensitivity of the project's net present value to the estimation of the cost of equity. The China project's...

## Flotation Costs

When a company raises new capital, it generally seeks the assistance of investment bankers. Investment bankers charge the company a fee based on the size and type of offering. This fee is referred to as the flotation cost. In the case of debt and preferred stock, we do not usually incorporate flotation costs in the estimated cost of capital because the amount of these costs is quite small, often less than 1 percent.39 However, with equity issuance, the flotation costs may be substantial, so we...

## Estimating Beta and Determining a Project Beta

When the analyst uses the CAPM to estimate the cost of equity, he or she must estimate beta. The estimation of beta presents many choices as well as challenges. One common method of estimating the company's stock beta is to use a market model regression of the company's stock returns Rt against market returns Rm over T periods where a is the estimated intercept and b is the estimated slope of the regression that is used as an estimate of beta. However, beta estimates are sensitive to the method...

## Applying the Cost of Capital to Capital Budgeting and Security Valuation

With some insight now into the calculation of the cost of capital, let us continue to improve our understanding of the roles it plays in financial analysis. A chief use of the marginal cost of capital estimate is in capital-budgeting decision making. What role does the marginal cost of capital play in a company's investment program, and how do we adapt it when we need to evaluate a specific investment project A company's marginal cost of capital MCC may increase as additional capital is raised,...

## Designing Your Personal Study Program

Create a Schedule - An orderly, systematic approach to examination preparation is critical. You should dedicate a consistent block of time every week to reading and studying. Complete all reading assignments and the associated problems and solutions in each study session. Review the LOS both before and after you study each reading to ensure that you have mastered the applicable content and can demonstrate the knowledge, skill, or ability described by the LOS and the assigned reading. Use the...

## The Capital Budgeting Process

The specific capital budgeting procedures that a manager uses depend on the manager's level in the organization, the size and complexity of the project being evaluated, and the size of the organization. The typical steps in the capital budgeting process are as follows Step One Generating Ideas Investment ideas can come from anywhere, from the top or the bottom of the organization, from any department or functional area, or from outside the company. Generating good investment ideas to consider...

## Ranking Conflicts between NPV and IRR

For a single conventional project, the NPV and IRR will agree on whether to invest or to not invest. For independent, conventional projects, no conflict exists between the decision rules for the NPV and IRR. However, in the case of two mutually exclusive projects, the two criteria will sometimes disagree. For example, Project A might have a larger NPV than Project B, but Project B has a higher IRR than Project A. In this case, should you invest in Project A or in Project B Differing cash flowr...

## How To Use The Cfa Program Curriculum

Congratulations on your decision to enter the Chartered Financial Analyst CFA Program. This exciting and rewarding program of study reflects your desire to become a serious investment professional. You are embarking on a program noted for its high ethical standards and the breadth of knowledge, skills, and abilities it develops. Your commitment to the CFA Program should be educationally and professionally rewarding. The credential you seek is respected around the world as a mark of...

## Ranking Conflict Due to Differing Cash Flow Patterns

Projects A and B have similar outlays but different patterns of future cash flows. Project A realizes most of its cash payoffs earlier than Project B. The cash flows, as well as the NPV and IRR for the two projects, are shown in Table 7. For both projects, the required rate of return is 10 percent. TABLE 7 Cash Flows, NPV, and IRR for Two Projects with Different Cash Flow Patterns TABLE 7 Cash Flows, NPV, and IRR for Two Projects with Different Cash Flow Patterns

## Features of the Curriculum

Optional Segments - You should read all of the pages for an assigned reading. In some cases, however, we have reprinted an entire chapter or article and marked those parts of the reading that are not required as optional. The CFA examination is based only on the required segments, and the optional segments are included only when they might help you to better understand the required segments by seeing the required material in its full context . When an optional segment begins, you...

## Basic Principles Of Capital Budgeting

Capital budgeting has a rich history and sometimes employs some pretty sophisticated procedures. Fortunately, capital budgeting relies on just a few basic principles. Capital budgeting usually uses the following assumptions 1. Decisions are based on cash flows. The decisions are not based on accounting concepts, such as net income. Furthermore, intangible costs and benefits are often ignored because, if they are real, they should result in cash flows at some other time. 2. Timing of cash flows...