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Corporate Finance Essentials, Certification link.

1. Returns, Volatility, and Beta

Periodic return source : (1) capital gain or loss; (2) cash flow.

  • Arithmetic Mean Returns: representing a simple average.
  • Geometric Mean Returns: reflects the average rate at which an investment grows over time, considering compounding effects.
  • Arithmetic Mean Returns is always higher than Geometric Mean Returns. Misleading information can lead to poor investment decisions.

Volatility (SD - Standard Derivation) of returns. measure of variability,

Beta measure of relative risk (referencing the market), reaction of an asset to fluctuations in the market. $StockRisk = \beta^{2} SystematicRisk + IdiosyncraticRisk $

2. Correlation and Diversification

Portfolio risk - we want to reduce fluctuation, with diversified correlation.

  • Correlation (Rho) the sign and the strength of the relationship between two variables. 👍 Country Correlation Matrix
  • Diversification : usually thought of in terms of risk reduction.
    1. Investers do not really want to reduce risk. As high risk is linked with high expected return.
    2. Investers do not really want to maximize returns. which would also maximize risk.
    3. Investers want to maximize risk-adjusted returns. (a “best” combination, thought diverification)
  • The lower the correlation between assets, the higher the benfits of diverification.

3. CAPM and the Cost of Capital

  • Cost of captial is related to RISK (not cash flows).
  • The weighted-average cost of capital (WACC).
    1. From the point of view of investors, the average required return on the capital provided.
    2. From the point of view of the company, the average cost of raising capital.
    3. A hurdle rate : the minimum required return on the company’s investments.
  • $R_{WACC} = x_{D} (1-t_{c})R_{D} + x_{E}R_{E}$
    • $R_D$ $R_E$ are the required return on debt and equity.
    • $t_c$ is the corporate tax rate, $ (1-t_{c})R_{D}$ is the after-tax cost of debt.
    • x are proportions of the debt and equity. (we want to find the best proportions)

The debt tax shield $ (1-t_{c})R_{D}$. We debt we will pay fewer tax, since we pay the interest, which has a effect of discount on the required return of debt.

Required returns:

  • The corporate tax rate.
  • The cost of debt.
  • The cost of equity and the CAPM.
  • The proportions of debt and equity.