# Business Finance Final Exam

Cost of Equity

The cost of equity is the return that stockholders require for their investment in a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:

Dividend Capitalization Model

Cost Of Equity= Dividends per share for current year / current market value of stock + dividend growth rate

Capital Asset Pricing Model

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

Risk Free Rate + Beta (Expected Market Return)

Risk Free Rate + Beta (Expected Market Return)

Weighted Average Cost Of Capital

A calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources – common stock, preferred stock, bonds and any other long-term debt – are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

Security Market Line

The security market line (SML) is simply a plot of expected returns of investments with respect to its beta, market risk. Expected values are calculated with the following equation:

Es = rf + Bs(Emkt – rf)

rf = the risk-free rate

Bs = the beta of the investment

Emkt = the expected return of the market

Es = the expected return of the investment

Es = rf + Bs(Emkt – rf)

rf = the risk-free rate

Bs = the beta of the investment

Emkt = the expected return of the market

Es = the expected return of the investment

Portfolio Weight

The percentage composition of a particular holding in a portfolio. Portfolio weights can be simply calculated using different approaches: the most basic type of weight is determined by dividing the dollar value of a security by the total dollar value of the portfolio. Another approach would be to divide the number of units of a given security by the total number of shares held in the portfolio.

Expected Return on Portfolio

calculated as the weighted average of the likely profits of the assets in the portfolio, weighted by the likely profits of each asset class. Expected return is calculated by using the following formula:

E(R) = w1R1 + w2Rq + …+ wnRn

E(R) = w1R1 + w2Rq + …+ wnRn

Portfolio Beta

Is the sum of the weight of each asset times the beta of each asset.

Payback Period

= Cost of Project / Annual Cash Inflows

The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.

The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.

IRR

The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that defines the IRR for this project is

NPV

The NPV of a project is the PV of the outflows minus the PV of the inflows.

The difference between the present value of cash inflows and the present value of cash outflows.

The difference between the present value of cash inflows and the present value of cash outflows.

Required Return on Stock

Dividend year 1 divided by base price plus the growth rate.

Stock Price

Dividend year 1 / (R-G)

R= required rate

G=growth rate

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