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Finance Mid ii Syllabubs Chapter number 12,13, & 16

Chapter #12

An Alternative View of Risk and Return

➤CAPM:
CAPM : shows the relationship between expected return and market risk.

⇨The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its
risk and the time value of money are compared to its expected return.

In case of CAPM the expected return of any security is just a function of

one factor

>>which is systematic risk.

◑Here Risk free rate example can be Treasury bill or note

◑Exoected return of the market (historical average, e.g. average of past 10years return)

◑Beta looks at the relationship between investment and market. The closer the beta is
to 1 the more stock moves like the market does.
➤Beta: Market risk premium(Rm-Rf) এর সা থ আমার security র excess
return িকভা ব response ক র।

⇨Beta: The beta of a potential investment is a measure of how much risk

the investment will add to a portfolio that looks like the market. If a stock is
riskier than the market, it will have a beta greater than one. If a stock has a
beta of less than one, the formula assumes it will reduce the risk of a
portfolio.

{Relationship between investment and market or systematic risk }

We capture the influence of a systematic risk on a stock by using beta

coefficient,

⇨The magnitude of beta describes how great an impact a systematic risk

has on a stock's return.

⇨Beta - a measure of systematic risk (market risk) /It tells us the

response of stock's returnto a systematic risk.

[মাগনা প াচালঃ যিদ কা না company র stock positively related হয় কান একটা

systematic risk এর সা থ (for example : inflation) তাহ ল বল ত হয় positive
inflation beta (inflation বাড় ল stock price বাড় ব).

Negatively related হ ল inflation বাড় ল stock price কম ব আর uncorrelated

হ ল inflation beta 0 হ ব।
➤Systematic Risk vs Unsystematic risk.

⇨Systematic Risk /Market Risk/Undiversifiable Risk:

-refers to the risk inherent to the entire market or market segment -it is
caused by factors beyond the control of a specific company or individual.

i.e. Inflation, Interest rate, GNP, Natural disaster, Climate change etc.

⇨Unsystematic /Nonsystematic /Specific risk/Residual Risk/Diversifiable

risk --- Specific to a company
➤Why is the return of two companies are related?

Unsystematic part of the return of two companies are unrelated but systematic portions
are related that's why both the two companies' returns are influenced by the sane
systematic risks therefore there returns are related to each other. For example inflation
(surprise) will affect almost all company of that economy.

✔✔ Factor Model : (Three-Factor Model)

R = Actual return

R̅ = The expected return

U = Unexpected part or Total risk (systematic + unsystematic)

m = Systematic risk

ε = Unsystematic risk

F is for Surprise

⇨F = Actual - expected
➤Single Factor model is generally known as Market Model after a slight modifications.
Researchers generally use Single factor model or one-factor model.Instead of using all
sorts of economic factor they use an index of stock market returns __i.e. S&P 500 or
any other index.

➤Stock Portfolio (where each stock portfolio follows one factor model)
িক যিদ আমরা stock portfolio create কির এবং ত কটা stock যিদ one factor model
follow ক র তাহ ল তখনই weight এর কথা আস ব।

portfolio আস ল তখন weight এর িবষয় আ স Because আমা দর ক determine কর ত হয়

"The portion of wealth we are gonna invest in each of the stock"

Weight বর করা খুব easy - total কত investment করা হ য় ছ portfolio সটা denominator
portion এ আর যই stock এর weight বর কর ত চাই সটার investment এর amount
numerator portion এ

☞মূলত একটা portfolio ত যত ল asset থা ক তার weighted Average return ই হ লা ঐ

portfolio থ ক return.

So, the portfolio return is -

☞Weight ক denote করা হ ব X ারা।

◑Weight বর করা তা িশখলাম, এখন R এর value (R1, R2...) িকভা ব বর কর বা?
⇨Simple উপ র য one factor model দয়া আ ছ সটায় ত ক র িনধািরত Value বসা ত হ ব।
আর subscript i এর জায়গায় 1, 2... িদ য় Stock এর numbering ক র R1, R2 এর value পাওয়া
যা ব।
➤Show the relationship between factor

(A factor is Excess return. i.e. F = Actual - expected) and beta.

☞(Factor x beta) = Excess return.

➤Can you reduce both systematic and unsystematic risk? Or any one of them? Explain
graphically

No, systematic risk cannot be eliminated regardless how many securities we include
there. But unsystematic risk can be reduced by diversification and including more
Securities.
 Chapter #13

Risk, Cost of Capital, and Valuation

⇨What is cost of Capital?

Cost of Capital: cost of Capital is the rate of return that a firm must earn on the projects
in which it invests to maintain its market value and attract funds.

Value of the firm: It indicates the current value of share and bond .

⇨WACC: Cost of equity + cost of debt.

⇨Leverage : The presence of operating fixed cost and financial fixed cost in the firms'
total capital structure.

⇨Operating Leverage : the presence of operating fixed cost in the capital structure,,
(operating expenses )

⇨Financial Leverage: The presence of financial fixed cost in the capital structure ,,,
(cost of debt)

⇨NPV: the present value of future cash inflows minus initial investment.

⇨IRR: IRR is the rate at which -the present value.

➤Why should a firm estimate the cost of its different sources of capital?

In order to determine the appropriate discount rate a firm has to estimate its cost of
capital.

➤If a firm has extra cash, Will its investors let the cash for reinvestment or will they
want them as dividend?

Investors will desire for higher expected return considering comparable risk. Investors
will want the firm to reinvest their dividends to its project only when they will find it
more profitable (expected return on the project is higher considering comparable risks
involved) that that of investing otherwise.
➤ Do you agree that "The discount rate of a project should be the expected return on a
financial asset of comparable risk." Give your opinion.

The discount rate is often known as the required rate of return on the project. Actually
"The discount rate", " The required rate of return ", and " The cost of capital" are
analogous terms used interchangeably.

The important point here is that -The project is accepted only when it generates a return
more than the required rate of return. The required rate of return is the amount of
money that a firm needs to earn to cover its cost of capital.

➤Why does CAPM is used for?

CAPM is generally used for estimating the cost of equity Capital. CAPM is used for
determining investors' expected required rate of return.

The same thing is the cost of equity capital from the firms' perspective.

Investors do not let the firm know what their required returns are.

So firms have to get investors' required rate of return by CAPM.

⇨(Rm-Rf) the different is often known as the expected excess market

return or market risk premium.
➤SML -399 page.
➤What are the methods are there for determining market risk premium or the
expected excess market (Rm-Rf)?
Market risk premium can be determined by either "Using historical date" or using "DDM"

⇨Using Historical Data : The difference between the expected return on the market
portfolio and the risk free rate (Rm-Rf) is called the market risk premium. We can use
historical approach, for example : In order to determine Rf (risk free rate) we can take
the average rate of return for treasury bills for past 10 years.

⇨Using DDM:

The dividend discount model (DDM) is a quantitative method used for predicting the
price of a company's stock based on the theory that its present-day price is worth the
sum of all of its future dividend payments when discounted back to their present value.

By rewriting the formula we can easily extract r and that can determine the total
expected return on the market as a whole.
➤Beta,,,, [Beta কথন]

Beta is undoubtedly an important element in CAPM

◑Exam question or financial journal এ beta normally দয়াই থা ক।

But Real life এ financial role play করার সময় আমা দর beta calculation ক র িন ত হয় excel
এ।
◑Simply beta হ একটা Measurement যটায় কা না company (for example : XYZ Co.)
এর stock এর volatility ক measure করা হয়।
এক কথায়, কা না কা ািনর individual stock এর য return আমরা পাই সটা ঐ market index
এর return এর িহ স ব কতটা volatile তা িহসাব করা হয়।
◑◑ধ রা, Market Index এ ২০% change হ ল আমা দর stock return 10% change হয়। তাহ ল
1% এ কত হয় ঐটাই হ লা beta.

✔
◑Date এ িদ ক ল কর ল দখ ব য ১ স াহ পর পর price দয়া আ ছ Stock এর এবং S&P 500
এর।
◑আমা দর return বর করার িনয়ম টা হ লা যই তাির খর return বর কর বা সই তাির খর price
ভাগ আ গর তাির খর price মাইনাস 1.
✔✔

◑সুতারং return এর ঘর ২য় ঘর থ ক পাওয়া যা ব। এভা ব আমরা Individual Stock এবং S&P

500 এর return বর ক র িনলাম।

◑এবার beta বর করার পালা

excel এ = িল
খ slope command িদ ত হ ব থ ম individual stock এর returns লা select
কর ত হ ব তারপর কমা S&P 500 index এর return.
➤Calculating Beta Manually :

☞SD :In statistics, the standard deviation (σ ) is a measure that is used to quantify the
amount of variation or dispersion of a set of data values.[Squared root of variance ]

☞ standard deviation is the measurement of total risk not only systematic or

unsystematic risk.

☞Variance : it measures how far a set of (random) numbers are spread out from their
average value.

☞In probability theory and statics , covariance is a measure of the joint variability of
two random variables.

Covariance evaluates how the mean values of two variables move together.

[Covariance measures the directional relationship between the returns on two assets. A
positive covariance means that asset returns move together while a
negative covariance means they move inversely.]
➤Determinants Of Beta :