1-Why should financial decision makers obtain a good estimate of a firm’s cost of capital
The firm’s Cost of capital is the overall required return on the firm as a whole. It is the appropriate discount rate to use for cash flows similar in risk to the overall firm. A firm uses both debt and equity capital, this overall cost of capital will be a mixture of the returns needed to compensate its creditors and its stockholders. In other words, a firm’s cost of capital will reflect both its cost of debt capital and its cost of equity capital.
2-What are the consequences of using a discount rate that is higher or lower than a firm’s
true required return
Cost of capital is the firm’s minimum required return on a new investment. The required return is what the firm must earn on its capital investment in a project just to break even. Notice that when we say an investment is attractive if its expected return exceeds what is offered in financial markets for investments of the same risk, we are effectively using the internal rate of return (or) IRR.
3-Why is beta thought to be a more relevant measure of risk than standard deviation for a diversified investor
Standard deviation measures both a stock’s market risk and unique risk. However, a diversified investor is no longer concerned with unique risk, or at least not concerned over the small portion that remains after portfolio diversification. Beta measures only the market risk of the stock, that type of risk that cannot be diversified away. The stock’s returns may be more or less volatile than the market portfolio and beta is an indication of that sensitivity
4- Discuss the relationship between risk and return.
In order for investors to be willing to purchase an asset, the expected return must be adequate to compensate for the risk of the asset. The larger the risk, the larger the expected return.
5-Coming out of depression, small stocks in the U.S. earned their highest one year historical return of 143% in 1933. However, in the four years prior to that you would have lost (going from 1929 to 1932, in order) about 50%, 40%, 50%, and 5%. Suppose you started into this five year stretch with $10,000 invested. How much did you still have heading into 1933 how much would you have at the end of that year
Based on these numbers, do you think the 143% return should be included in the return
If you began with $10,000, your investment declines (year-by-year) to $5,000, $3,000, $1,500, and $1,425. So, you begin 1933 with only $1,425 left. At the end of that year, you have $3,463, a far cry from your starting point of $10,000. The astute student will point out that by the time the 143% return rolls around, the value of the investment has declined so much that the large single return is due in part to the low amount of funds invested at the start of that year. Nonetheless, the return should be included in the series. In fact, this period of time significantly reinforces the lessons we draw from this series of returns.
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