Forum

What is the difference between arithmetic and geometric averages?

The geometric  average return:
·         Tells you what you actually earned per year on average, compounded annually.
·         Is very useful in describing the actual historical investment experience.

The arithmetic  average return:
·         Tells what you earned in a typical year and is an unbiased estimate of the true mean of the dictribution.
·         Is very useful in making estimates of the future


Explain what the Security Market Line (SML) represent. What’s the implication of an asset return that lie above the SML line? Below the SML line?

SML represent both for all individual securities and for all possible portfolios;  SML relates expected return to beta. Securities lying above SML are underpriced. Their prices must rise until their expected returns lie on the line.

Explain why risk – averse investors should only hold efficient portfolios?

Here, efficiency means the highest expected rate of return on an investment for a specific level of risk. The primary starting point for portfolio theory requires an assumption that investors are risk averse. Thus, an investor will take on increased risk only if compensated by higher expected returns.


Why do we use the after tax values for cost of debt but not for the cost of equity?

Interest expense is tax deductible. Therefore, when a company pays interest, the actual cost is less than the expense. As an example, consider a company in the 34% marginal tax bracket that pays $100 in interest. The company’s after-tax cost is only $66.

Explain why it is important to use the market values of debt and equity rather than book values to calculate a firm’s WACC?

The WACC (Weighted Average Cost of Capital) is the minimum return that the company must earn on existing asset base to satisfy  its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a numbers of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pensions liabilities, executive stock options, governmental subsidies and so on. Different securities are expected to generate different return. The WACC is calculated taking into account the relative weights of each component of the capital structure  and is used to see if the investment is worthwhile to undertake.   
For example, the rate applied to determine the cost of debt (Rd) should be the current market rate that company is paying on its debt. If the company is not paying market rates, an appropriate market rate are payable by the company should be estimated.

Read More: 



Comments