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Finance 1 Week 6 Summary
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Finance 1 Week 6 Summary including readings
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Week 6:Preparation: Chap 12: Estimating the
Cost of Capital
The COC should include a risk premium.
The COC is the best expected return available in the market on investments with
similar risk.
The CAPM provides a practical way to ID an investment with similar risk. Under
CAPM, the market portfolio is a well-diversified, efficient portfolio representing
the non-diversifiable risk in the economy.
Investment have similar risk if they have the same sensitivity to market risk, as
measured by their beta with the market portfolio.
The CAPM Equation for the COC (Security Market Line): r i = rf + [ßi x (E[RMkt] –
rf)]Risk premium for security I
Investors will require a risk premium comparable to what they would earn taking
the same market risk through an investment in the market portfolio.
The proportion of each security in the market portfolio should correspond to the
proportion of the total market that each security represents.
MVi = (Number of Shares of i Outstanding) x (Price of i per Share)
xi = (Market Value of i) / Total Market Value of All Securities in the Portfolio =
MVi/ ∑jMVj
A Value-weighted portfolio: a portfolio in which each security is held in proportion
to its market capitalization. It is also an equal ownership portfolio: is hold an
equal fraction of the total number of shares outstanding of each security in the
portfolio.
A value weighted portfolio is also a passive portfolio because very little trading is
required to maintain it.
A market index: reports the value of a particular portfolio of securities.
A price-weighted portfolio holds an equal number of shares of each stock,
independent of their size.
Index funds: investment in market index portfolios. Exchange-traded funds
represent these portfolios (ETF: a security that trades directly on an exchange,
like a stock, but represents ownership in a portfolio stock.)
Market proxy: a portfolio whose return they believe closely tracks the true
market portfolio.
rMkt = Div1/P0 + g = Dividend Yield + Expected Dividend Growth Rate
Ideally, we would like to know the security ß in the future, so how sensitive will
its future returns be to market risks.
ß corresponds to the slope of the best-fitting line in the plot of the security’s
excess returns VS the market excess return.
Linear regression: the statistical technique that identifies the best fitting line
through a set of points. In ≠ Linear equations, can present error (or residual)
terms: the deviation from the best-fitting line and is zero on average.
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