conceptual questions (1)

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University of Washington *

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Finance

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Jan 9, 2024

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docx

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Stock 1. What rights come with a share of stock? 2. Which two components make up the total return to an investor in a share of stock? 3. What does the dividend discount model say about valuing shares of stock? 4. What is the relationship between the return from reinvesting cash flows and the change in the price of the stock? 5. How can the dividend discount model be used with changing growth rates in future dividends? 6. What are some of the drawbacks of the dividend discount model? 7. What are the advantages of valuing a stock based on discounted free cash flows? 8. Explain the connection between the FCF valuation model and capital budgeting. 9. What is the intuition behind valuation by multiples and what are the major assumptions? 10. What are the limitations of valuation by multiples? 11. What is an efficient market? 12. How do interactions in a market lead to information being incorporated into stock prices? 13. Why does market efficiency lead a manager to focus on NPV and free cash flow?
Risk and Return 1. What does the historical relation between volatility and return tell us about investors’ attitude toward risk? 2. What are the components of a stock’s realized return? 3. What is the intuition behind using the average annual return as a measure of expected return? 4. How does standard deviation relate to the general concept of risk? 5. How does the relationship between the average return and the historical volatility of individual stocks differ from the relationship between the average return and the historical volatility of large, well diversified, portfolios? 6. Consider two local banks. Bank A has 100 loans outstanding, each for $1 million, that it expects will be repaid today. Each loan has a 5% probability of default, in which case the bank is not repaid anything. The chance of default is independent across all the loans. Bank B has only one loan of $100 million outstanding that it also expects will be repaid today. It also has a 5% probability of not being repaid. Explain the difference between the type of risk each bank faces. Assuming you are averse to risk, which bank would you prefer to own? 7. What is meant by diversification and how does it relate to common versus independent risk? 8. Which of the following risks of a stock are likely to be unsystematic, diversifiable risks and which are likely to be systematic risks? Which risks will affect the risk premium that investors will demand? a. The risk that the founder and CEO retires. b. The risk that oil prices rise, increasing production costs. c. The risk that a product design is faulty and the product must be recalled. d. The risk that the economy slows, reducing demand for the firm’s products. e. The risk that your best employees will be hired away. f. The risk that the new product you expect your R&D division to produce will not materialize. 9. What is the difference between systematic and unsystematic risk?
10. There are three companies working on a new approach to customer tracking software. You work for a software company that thinks this could be a good addition to its software line. If you invest in one of them versus all three of them: a. Is your systematic risk likely to be very different? b. Is your unsystematic risk likely to be very different? 11. If you randomly select 10 stocks for a portfolio and 20 other stocks for a different portfolio, which portfolio is likely to have the lower standard deviation? Why? 12. Why doesn’t the risk premium of a stock depend on its diversifiable risk? 13. Your spouse works for Southwest Airlines and you work for a grocery store. Is your company or your spouse’s company likely to be more exposed to systematic risk?
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