PART 5 Risk and Return

Concept Questions
Standard Deviation is the measurement of the uncertainty in the distribution of possible
outcomes.
 The bigger the Standard Deviation, the bigger the uncertainty, therefore, the bigger the
risk.
For the market: Beta = 1
Covariance measures the direction of a relationship between two variables, while correlation
measures the strength of that relationship.
12.1a What are the two parts of total return?
Income component + K gain/loss.
12.1b Why are unrealized capital gains or losses included in the calculation of returns?
Unrealized capital gains or losses included in the calculation of returns because indirectly.
unrealized portion is also a gain to the company on a particular investment, so to get accurate
returns we will include both unrealized capital gains or losses.
12.1c What is the difference between a dollar return and a percentage return? Why are
percentage returns more convenient?
more convenient to summarize information about returns in percentage terms, rather than
dollar terms, because that way your return doesn’t depend on how much you actually invest
=>>How much do we get for each dollar we invest?
12.2b Why doesn’t everyone just buy small stocks as investments?
Small-cap company has a wider range of risk distribution. Risk averse investor would not favor
the volatility of small-cap stock while risk lovers are compensated with higher return probability
12.3a What do we mean by excess return and risk premium?
risk premium: the difference between the average return earned and risk free rate.
= average return - risk free rate
“excess” return: the additional return we earn by moving from a relatively risk-free investment
to a risky one
= return on S - risk free rate
12.3b What was the real (as opposed to nominal) risk premium on the common stock portfolio?
The real risk premium is the expected rate on the common stock portfolio over the life of the
portfolio.
12.3c What was the nominal risk premium on corporate bonds? The real risk premium?
Real i rate = (1+nominal i rate)/(1+inflation rate) - 1
The nominal risk premium is the difference between real risk premium on corporate bond and
the historical nominal rate.
12.3d What is the first lesson from capital market history?
every risky asset, will earn a risk premium. There is a reward for taking risk, reward is the risk
premium.
geometric average return earned per year on average, compounded annually
= [(1+r1)+(1+r2)+.......+(1+rn)]^(1/n) - 1
arithmetic average return what you earned in a typical year
= Total Value of the Return/Total Nu of Returns
arithmetic average return is probably too high for longer periods and the geometric average is
probably too low for shorter periods
if you are using averages calculated over a long period to forecast up to a decade or so into the
future, arithmetic average.
doing very long forecasts covering many decades, use the geometric average.
CHAPTER 5 Financial Leverage and Capital Structure
Cost of Ordinary Shares: Internal Funding: RE, self-generated, cheapest
External Funding: E, D
Pecking order: RE, D, E.

16.3a What does M&M Proposition I state?

16.3b What are the three determinants of a fi rm’s cost of equity?
1.the required rate of return on the firm's assets - Ra
2. the firms cost of debt - Rd
3. the firm's debt-equity ratio - D/E
16.3c The total systematic risk of a firm’s equity has two parts. What are they?
The total systematic risk of the firm’s equity thus has two parts: business risk and financial risk.
The first part (the business risk) depends on the firm’s assets and operations and is not affected
by capital structure. Given the firm’s business risk (and its cost of debt), the second part (the
financial risk) is completely determined by financial policy.
CHAPTER 17 Dividends and Payout Policy
17.1a What are the different types of cash dividends?

 Regular cash dividends.

 Extra dividends (may or may not be repeated in the future)
 Special dividends (not likely to repeat, one-time pmt)
 Liquidating dividends (liquidation of the business if there is any left)
17.1b What are the mechanics of the cash dividend payment?
Commonly, public companies pay regular cash dividends four times a year. The decision to pay
dividend rests in the hands of the board of directors. When a dividend has been declared, it
becomes a debt of the firm and cannot be rescinded easily. Sometime after it has been
declared, a dividend is distributed to all shareholders as of some specific date. Can be
expressed in terms of dollars per share ( dividends per share), the dividend yield or as a % of
net income or EPS.
17.1c How should the price of a stock change when it goes ex dividend?
In general, we expect that the value of a share of stock will go down by about the dividend
amount when the stock goes ex dividend. The key word here is about. Because dividends are
taxed, the actual price drop might be closer to some measure of the after-tax value of the
dividend. Determining this value is complicated because of the different tax rates and tax rules
that apply for different buyers
17.2a How can an investor create a homemade dividend?
This means that dissatisfied stockholders can alter the firm’s dividend policy to suit themselves,
by reinvesting dividends or selling shares of stock.. As a result, there is no particular advantage
to any one dividend policy the firm might choose.
An individual preferring high current cash flow but holding low-dividend securities can easily
sell off shares to provide the necessary funds. Similarly, an individual desiring a low current cash
flow but holding high-dividend securities can just reinvest the dividend.
17.2b Are dividends irrelevant?
True or false: Dividends are irrelevant.
2. True or false: Dividend policy is irrelevant.
The first statement is surely false, and the reason follows from common sense. Clearly,
investors prefer higher dividends to lower dividends at any single date if the dividend level is
held constant at every other date. To be more precise regarding the first question, if the
dividend per share at a given date is raised while the dividend per share at every other date is
held constant, the stock price will rise. The reason is that the present value of the future
dividends must go up if this occurs. This action can be accomplished by management decisions
that improve productivity, increase tax savings, strengthen product marketing, or otherwise
improve cash flow.
The second statement is true, at least in the simple case we have been examining. Dividend
policy by itself cannot raise the dividend at one date while keeping it the same at all other
dates. Rather, dividend policy merely establishes the trade-off between dividends at one date
and dividends at another date. Once we allow for time value, the present value of the dividend
stream is unchanged. Thus, in this simple world, dividend policy does not matter because
managers choosing either to raise or to lower the current dividend do not affect the current
value of their firm. However, we have ignored several real-world factors that might lead us to
change our minds; we pursue some of these in subsequent sections.
17.3a What are the tax benefits of low dividends?
Capital gains have been taxed at somewhat lower rates than dividends (at ordinary income tax
rates), and the tax on a capital gain is deferred until the stock is sold. This second aspect of
capital gains taxation makes the effective tax rate much lower because the present value of the
tax is less.
17.3b Why do flotation costs favor a low payout?
Selling new stock can be very expensive. If we include flotation, then we will find that the value
of the stock decreases if we sell new stock. If two firms are identical, then the one with the
higher payout will have to periodically sell some stock to catch up. Because this is expensive, a
firm might be inclined to have a low payout.
17.4a Why might some individual investors favor a high dividend payout?
The discounted value of near dividends is higher than the present worth of distant dividends.
Between “two companies with the same general earning power and same general position in
an industry, the one paying the larger dividend will almost always sell at a higher price.
many individuals desire current income. The classic example is the group of retired people and
others living on a fixed income. However, this is not always the case bc of homemade
dividends.
TAX AND OTHER BENEFITS FROM HIGH DIVIDENDS if the policy favour high yields stocks.
17.4b Why might some nonindividual investors prefer a high dividend payout?
Tax-Exempt Investors: like widows and orphans, this group thus prefers current income, the
difference is they hold large amount of stock
Eg: university endowment fund, trust funds
Corporate Investors: exclusion does not apply to capital gains, this group is taxed unfavorably
on capital gains. As a result of the dividend exclusion, high-dividend, low-capital gains stocks
may be more appropriate for corporations to hold
Dividend exclusion: allows corporations to subtract a portion of dividends received when they
calculate their taxable income, only apply to corporate entities and the investments that they
have in other companies

17.5b What is a dividend clientele? All things considered, would you expect a risky firm with
significant but highly uncertain growth prospects to have a low or high dividend payout?
The clientele effect argument states that different groups of investors desire different levels of
dividends. When a firm chooses a particular dividend policy, the only effect is to attract a
particular clientele. If a firm changes its dividend policy, then it just attracts a different clientele.
17.8a What is the effect of a stock split on stockholder wealth?
17.8b How does the accounting treatment of a stock split differ from that used with a small
stock dividend?