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Questions and Answers
Financial resources available to a company in the form of equity or debt is also known as ______.
Financial resources available to a company in the form of equity or debt is also known as ______.
capital
Which of these options are correct? (Select all that apply)
Which of these options are correct? (Select all that apply)
What is a capital market?
What is a capital market?
A market where investors provide borrowers with medium to long-term financing, typically in the form of equity or debt.
What is a money market?
What is a money market?
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Which of the following is NOT a characteristic of a perfect capital market?
Which of the following is NOT a characteristic of a perfect capital market?
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Informational efficiency means all market participants have access to all information.
Informational efficiency means all market participants have access to all information.
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What are prospectuses, and where do they come from?
What are prospectuses, and where do they come from?
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Company financial statements are only produced by publicly traded companies.
Company financial statements are only produced by publicly traded companies.
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What is the primary role of information in a capital market?
What is the primary role of information in a capital market?
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Weak-form information efficiency implies that past information does not influence current market prices.
Weak-form information efficiency implies that past information does not influence current market prices.
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Semi-strong information efficiency means that investors cannot use public information to gain an advantage in the market.
Semi-strong information efficiency means that investors cannot use public information to gain an advantage in the market.
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In a strong-form efficient market, investors cannot gain an advantage using any type of information, including private information.
In a strong-form efficient market, investors cannot gain an advantage using any type of information, including private information.
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What is the relationship between risk and return in investment?
What is the relationship between risk and return in investment?
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What is the primary objective of portfolio management?
What is the primary objective of portfolio management?
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What is Markowitz diversification strategy?
What is Markowitz diversification strategy?
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What is the difference between diversifiable variance or risk and non-diversifiable variance or risk?
What is the difference between diversifiable variance or risk and non-diversifiable variance or risk?
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A portfolio selection theory, developed by Markowitz, suggests that all assets in a portfolio should have similar risk profiles.
A portfolio selection theory, developed by Markowitz, suggests that all assets in a portfolio should have similar risk profiles.
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Correlation refers to the degree of mutual dependency between two variables.
Correlation refers to the degree of mutual dependency between two variables.
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What is the goal of the CAPM?
What is the goal of the CAPM?
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CAPM is a model of individual decision-making.
CAPM is a model of individual decision-making.
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CAPM assumes investors are risk-averse and seek to maximize their utility.
CAPM assumes investors are risk-averse and seek to maximize their utility.
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CAPM assumes that all investors have homogeneous expectations regarding the returns of securities.
CAPM assumes that all investors have homogeneous expectations regarding the returns of securities.
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A risk-free investment is one where there is no possibility of losing any capital.
A risk-free investment is one where there is no possibility of losing any capital.
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A perfect capital market exists where investors have a wide range of investment options to choose from.
A perfect capital market exists where investors have a wide range of investment options to choose from.
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The “cost of equity” is the same as the expected return on an investment.
The “cost of equity” is the same as the expected return on an investment.
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Beta is a standardized measure of risk that can be used to compare different investment portfolios.
Beta is a standardized measure of risk that can be used to compare different investment portfolios.
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A stock with a beta of 1.5 is considered to be more volatile than a stock with a beta of 0.8.
A stock with a beta of 1.5 is considered to be more volatile than a stock with a beta of 0.8.
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A stock with a beta greater than 1 will always generate higher returns than the overall market.
A stock with a beta greater than 1 will always generate higher returns than the overall market.
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Market price risks are only applicable to the price of stocks.
Market price risks are only applicable to the price of stocks.
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Which of the following is NOT a market price risk?
Which of the following is NOT a market price risk?
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Equity price risk is specifically associated with fixed-income assets.
Equity price risk is specifically associated with fixed-income assets.
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Country risk is exclusive to the energy sector.
Country risk is exclusive to the energy sector.
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Liquidity risk is the risk that a company or bank may be unable to meet short-term financial demands.
Liquidity risk is the risk that a company or bank may be unable to meet short-term financial demands.
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A company's capital maintenance risk is only present during bankruptcy.
A company's capital maintenance risk is only present during bankruptcy.
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Information risk refers to the risk of receiving incomplete information about a financial instrument.
Information risk refers to the risk of receiving incomplete information about a financial instrument.
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Advocacy risk is the risk that a third party, such as a broker, will exploit the investor's interests for their own benefit.
Advocacy risk is the risk that a third party, such as a broker, will exploit the investor's interests for their own benefit.
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Conditions risk is the risk of acquiring an investment at favorable terms.
Conditions risk is the risk of acquiring an investment at favorable terms.
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What is the Sharpe ratio?
What is the Sharpe ratio?
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A higher Sharpe ratio indicates a better performance for the investment.
A higher Sharpe ratio indicates a better performance for the investment.
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The Treynor ratio is a more comprehensive measure of risk compared to the Sharpe ratio.
The Treynor ratio is a more comprehensive measure of risk compared to the Sharpe ratio.
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The Treynor ratio is particularly useful for comparing portfolios with different levels of risk.
The Treynor ratio is particularly useful for comparing portfolios with different levels of risk.
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Returns can be both time-weighted and money-weighted.
Returns can be both time-weighted and money-weighted.
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Study Notes
Capital Markets and Informational Efficiency
- Capital: financial resources available to a company, either equity or debt.
- Equity financing: a company's own resources.
- Debt financing: outside capital raised through loans.
- Capital market: a market for medium-to-long term financing of equity or debt.
- Money market: a market for short-term loans (up to a year).
- Perfect capital market: a theoretical market with frictionless transactions, perfect competition, rational market participants, and perfect information.
Perfect Capital Market Characteristics
- Frictionless: no costs or taxes, perfect sharing and trading of securities, free of regulatory restrictions.
- Perfect competition: participants are price takers; no single entity affects market price.
- Rationality: entities act logically and in their best interest.
- Informational efficiency: all participants have access to the same information.
Informational Efficiency
- Prospectuses: documents provided to investors, containing company information.
- Market sector analyses: by finance professionals and research firms.
- Company financial statements: reports for quarterly and annual periods.
- Information in the financial press: reports published by news sources.
- Information procurement and distribution: vital for market price changes.
- Target excess returns: aims for higher investment return.
- Liquid market: consistently has investors and sellers.
- Informationally efficient market: all market participants have instant access to the same information.
Portfolio Theory
- Risk-return ratio: higher risk, higher potential return.
- Investment portfolio: combining different securities.
- Markowitz diversification: goal is to balance risk and return for optimal portfolio construction.
- Diversification: reducing risk by spreading investments.
- Unsystematic risk: company-specific risk, reduced by diversification.
- Systematic risk (market risk): risk inherent in the market, cannot be reduced by diversification.
- Correlation: measure of mutual dependency between assets returns; value ranges from -1 to 1.
Capital Asset Pricing Model (CAPM)
- A model for determining the expected rate of return from the share of a company.
- Risk-free rate of return: return on risk-free investments.
- Expected market return: market return projected for equities..
- Beta coefficient: a measure of a security’s volatility of returns as compared to changes in the market rate.
- Importance of Beta: Indicates risk Exposure for a stock.
Measures of Risk and Performance
- Risk: unexpected potential loss.
- Market price risk: changes in stock, bond, and currency prices due to market movements.
- Volatility: range of price fluctuations.
- Foreign-exchange risk: risk of currency devaluation.
- Inflation risk: decline in purchasing power of assets.
- Interest rate risk: changes in interest rates affecting returns of bonds.
- Equity price risk: reflecting negative movements in individual company stocks.
- Country risk: risk of political intervention.
- Liquidity risk: risk company cannot meet short-term financial obligations.
- Capital maintenance risk: possibility of complete capital loss.
- Information risk: risk from insufficient investment information.
- Settlement and management risk: misuse of investor assets.
- Advocacy risk: representation acting against the best interests of the investor.
- Sharpe ratio: reward-to-risk-ratio- a measure of portfolio performance.
- Treynor ratio: reward-to-risk-ratio, considering systematic risk.
Stock Analysis
- Determining company value and future performance.
- Fundamental Analysis: intrinsic value via internal/external company data.
- Technical Analysis: analyzes stock prices and trends via charts.
- Innovative methods: including chaos theory and neural networks.
- P/E ratio: price per share divided by earnings per share.
- P/CF ratio: price per share divided by cash flow per share (future oriented valuation).
Capital Structure and Optimal Structure
- Capital structure: mix of debt, equity, and hybrid securities used to finance a business.
- Equity interest: grants shareholders voting rights, profits, assets in liquidation.
- Debt securities: grants creditors a right to payment at determined times; no influence over company decisions.
- Leverage effect states to increase the return on a company’s equity return. Borrowing cost(loans) must be lower than the return on the investment.
- Net Operating Income Approach: considers capital structure irrelevant to valuation.
- Debt-to-equity ratio is significant but no single optimal ratio exists. Market forces impact this.
Types of Financing
- Internal financing: funds from company profit, asset sales.
- External financing: funds from equity investors (stockholders), lenders, and other external sources.
- Debt financing: loans (secured/unsecured), financing with borrowing expenses.
- Debt/equity financing: combination of debt and equity financing.
- Equity financing: selling company stock.
- Liquidation financing: liquidation of assets for generating cash.
- Mezzanine financing: a bridge between debt and equity financing.
Financial Instruments: Collateral and Covenants
- Collateral: assets pledged.
- Loan covenants: strict conditions, ensuring borrower compliance and reducing risk to the lender.
Trade Credit
- Advantage for borrowers: quick capital availability, less formal standards.
- Disadvantage: dependencies on suppliers and potentially more costly.
Customer Loans
- Advantage for borrowers: quick availability of financing and may save costs compared to other methods.
- Disadvantage: potentially more costly, could compromise products and services.
Types of Personal Companies and Corporations (By Country)
- Different legal forms affect financing options and responsibilities.
Financial Ratios and Metrics Analysis
- Company valuation can be analyzed with financial ratios.
- Liquidity ratios (current, quick assets/liabilities).
- Leverage ratios (debt-to-equity).
- Profitability ratios (return on assets, return on equity).
- Activity ratios (inventory turnover, days sales outstanding).
Methods of Comparison in Capital Budgeting
- Static methods (cost comparison, profitability comparison, payback period)
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- Static methods assume a constant rate of return, not considering the time value of money.
- Dynamic methods (Net Present Value, Internal Rate of Return, Annuity method)
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- Dynamic methods consider the time value of money and the future cash flows from an investment.
Capital Budgeting: Project Evaluation Methods
- Capital budgeting: evaluating potential investments.
- Net Present Value (NPV): estimates the difference between future value of cash inflows and the present value of cash outflows.
- Internal Rate of Return (IRR): calculates the discount rate that makes the NPV equal to zero.
- Payback Method: measures the time required to recover the initial cost of an investment.
Financial Planning Concepts and Processes
- Financial planning: forecasting revenues and expenses.
- Setting/Forecasting budget forecasts.
- Cash budgeting: projecting cash flows
- Pro Forma financial planning: using financial assumptions and sales projections to project scenarios.
Business Valuation
- Business Valuation: determines the economic value of a company.
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- Value-based management.
- Individual valuation: sum of assets - liabilities.
- Total valuation: using projected future performance (relative to competitive companies)
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- Discounted cash flow (DCF): calculates present value of future cash flows.
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- Comparative value: estimates the value of a company based on the market price of similar companies.
- Economic Value Added (EVA): used to compute a company's performance relative to its cost of capital.
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