Factors Influencing The Cost Of Capital

Fama and French’s three factor model attempts to explain the variation of stock prices through a multifactor model that includes a size factor and BE/ME factor in addition to the beta risk factor. Fama-French model essentially extended the CAPM (which breaks up cause of variation of stock price into systematic risk which is non-diversifiable and idiosyncratic risk which is diversifiable) by introducing these two additional factors. Fama and French find that stocks with high beta didn’t have consistently higher returns than stocks with low beta and this indicates that beta was not a useful measure under their model. Their model is based on research findings that sensitivity of movements of the size and BE/ME factor constituted risk, and

The extracted data used includes monthly returns from January 1972 to July 2011. The assets are selected so that the portfolio contains the largest, most liquid, and most tradable assets. The choice of such a variety of assets across several markets was used in order to generate a large cross sectional dispersion in average return. It helped to reveal new factor exposure and define a general framework of the correlated value and momentum effects in various asset classes.

Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due

As a deep-discount brokerage, Ameritrade planned to improve its competitive position by price cutting, technology enhancements, and increased advertising in mid-1997. Before initiating the plan, Ameritrade needed know whether the investment returned more than it cost. We were hired to estimate the cost of capital correctly. The key question is to find suitable comparable firms to estimate Ameritrade’s asset beta, since it was a recently-listed firm. We thought discount brokerage companies were best due to same revenue resources. Proper risk-free rate and market risk premium should also be chosen carefully, and we used 30-year bonds YTM and the annual return difference

DFA’s investment strategy was centered on academic research, specifically on the findings of Banz’ “size effect” and Fama and French’s “book-to-market effect.” In Banz’ research, he found that small stocks consistently outperformed large stocks over the entire history of the stock market from 1926 through the late 1970s. See Exhibit 1 for overview of growth between large and small cap stocks.

In the years since 2000, a few investors have determined that their small cap portfolio outperformed their shares held in larger companies in terms of ROI (return on investment). The total dollar price earned was lesser; nevertheless the benefit percentage was

This document is authorized for use only by Yen Ting Chen in FInancial Markets and Institutions taught by Nawal Ahmed Boston University from September 2014 to December 2014.

Diversity investment among stock markets, bounds and nationally and internationally is the best me method of maintaining the risk of investment and expanding its growth. The fourth importance is the cost of single investment; the less money an investor pay; the more financial resources will have to take advantage on future investment opportunities that expand the return. Becker’s final advice of investment success was for investors to slick with their plan. “Lethargy bordering on sloth remains the cornerstone of our investment style”, Warren Buffett. Many investors get influenced by what goes around them and the media to end their investment prematurely or get involved in risky commitment outside of their goals.

This essay will highlight the use of Capital asset pricing model ( CAPM ) to be considered as a pricing theory model for assets . CAPM model helps investors to analyse the risk and what expectation to keep from an investment (Banz , 1981) . There are two types of risk

To justify whether it works, we first ran a regression on the Three-Factor Fama French Model (Market Excess Return, SMB and HML) from Jan 1972 to Dec 2012 respectively for the High-, 5-, Low-, and High-Minus-Low Portfolio. Then, we added momentum into the model to create a four-factor model (Momentum, Market Excess Return, SMB and HML) for the same period on a monthly basis. (See Exhibit 2).

In order to analyze the momentum effect of different specifications, stocks were divided into ‘winner’ stocks and ‘loser’ stocks according to their rankings.

The historic average returns from 1950 to 1996 and from 1929 to 1996 are given In Exhibit 3. We chose the latter time period as we considered it would give us a more reliable estimate of the risk-free rate by discounting both the Second World War and the Great Depression. It is necessary to evaluate the expected length of the project and utilize a risk free rate applicable for the same time period. Ameritrade is investing $100 million dollars in technology, which is considered a long-term investment, in order to become the largest brokerage firm. We consider their

As indicated by the case study S&P 500 index was use as a measure of the total return for the stock market. Our standard deviation of the total return was used as a one measure of the risk of an individual stock. Also betas for individual stocks are determined by simple linear regression. The variables were: total return for the stock as the dependent variable and independent variable is the total return for the stock. Since the descriptive statistics were a lot, only the necessary data was selected (below table.)

During a study by Jegadeesh and Titman (1993), the portfolios created using a strategy, which is based on the assumption that within a period of 3-12 months (short-term), the stocks that made gains (led to losses) in the past will make gains (lead to losses) in the future, obtained abnormal returns of 1% in each consecutive year. When the literature is examined, it is seen that very small number of studies paid regard to the power of adding the momentum factor to SMB and HML factors of Fama and French (WML-winners minus losers) in explaining stock returns. (Carhart 1997, Jegadeesh 2000, Liew and Vassalou 2000, Kim and Kim 2003, L’Her; Masmoudi; Suret 2004, Bello 2007, Carmichael and Coën 2008, Lam; Li; So 2009; Unlu,2012).

Economic theory proposes that there should be a strong link between economic activity and stock prices, given that its price is the discounted present value of the firm’s payout. If this payout is finally a function of real activity, such a link should exist.