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Test 3, Lecture 5 ReviewPROJECT ECONOMICSIn prior lectures, we discussed how uncertainty plays a role in capital budgeting. Now we try to relate this concept to the overall firm and our risk and return unit. In unit 2, we discussed Beta as a measure of the systematic risk of a firm. We talked in general terms of the volatility in stock returns and Beta. Now, we think about what creates volatility for a firmBeta: a risk index that measures the volatility of returns The higher the risk, the greater the volatility and the greater the betaVolatility is synonymous with standard deviationWhat Drives the Risk of a Firm?Cyclical Revenues: revenues that move with the economyIncreased cyclality increases volatility in earnings which increases betaOperating Leverage: percent of fixed costs versus the percent of variance costsAn increased percentage of fixed costs increases operating leverage which increases volatility in earnings and increases betaFinancial Leverage: percentage of debt on the balance sheetIncreased debt increases fixed interest payments which increases volatility in earnings which increases beta***Large Beta = cyclical revenue, high operating leverage, and high financial leverageRelating Volatility to Fixed CostsAn increased percentage of fixed costs increases volatility which increases standard deviation in earnings, which increases BetaAn increased percentage in fixed costs increases the change in EBITDA (between good and bad demand – see example)EBITDA is a proxy for cash flowsMeasuring the Impact of Operating LeverageThere are 2 Approaches to Measuring Operating Leverage:Pre-Tax Cash Flow Operating LeverageIf I increase sales by 1%, how much will cash flow increase (as a %)?Cash Flow Operating Leverage=1+FCEBITDAIf the firm can increase sales by 1%, they will increase CF by __%Accounting Operating LeverageBreak-Even AnalysisThere are 2 Basic Break-Even Approaches:Cash Flow Break-EvenEBITDA Break-Even: The number of units the firm needs to break even on cash flowsBreak-Even Quantity: the number of units needed to recover fixed costsBreakeven=FCP-VC=FCCMCross-Over Level of Unit Sales: unit sales required to favor the higher fixed cost alternativeAccounting Break-EvenJust adds in depreciation and amortizationPERSONAL FINANCESo far, we’ve learned to value stocks and bonds for investors. Now, we take a step back and look at how to get started investingThere are 6 Basic Types of Investments You Can Find on Wall St:Individual StocksIndividual BondsMutual Funds: a portfolio of stockMinimum investment of $1500-$3000Exchange Traded Funds (ETF): a basket of goods that trades all day long, like stocksMinimum investment of $100Very liquidOptions: the right to buy/sell an asset at a set priceYou want there to be big volatility when buying optionsThere are 2 Types of Options:Call Option (“long”): the right to buy at a certain priceYou are basically betting that the price is going to go upPut Option (“short”): the right to sell at a certain priceYou are basically betting that the price is going to fallCommodities: buying gold, platinum, or silverThere are 6 Ways to Invest in the Market:Full Service Broker (wealth manager)Fees are 1% of managed assetsUse this when you want nothing to do with your moneyLimited Service BrokerLess fees, less adviceOnline Trading:Companies like E-Trade and ScottradeCheapApp-Based TradingPlatforms called Acorn or RobinhoodMutual Fund CompanyYou can buy directly from a mutual fund companyEx: Vanguard DRIP (Dividend Reinvestment Plan)Very cheap but can only trade once a monthLow cost, low liquidityAdvantages and Disadvantages of These Accounts:CommissionsLiquidityInvestment OptionsAdviceFullHighHighManyGoodLimitedMediumMediumManyGood but self-directedOnlineLowMediumManyGood but self-directedApp-BasedLowMediumManyGood but self-directedMutual FundVariesLowLimitedLimitedDRIPVery LowNoneNoneNoneHow Does a Mutual Fund Work?You are investing in a mutual fund companyThe fund pools from many different investorsThe fund buys assets that meet the objectives of the mutual fundsWhen you start work, you will create a 401K Account, which is a retirement fundMost choices to invest in are mutual fundsAdvice #1: invest at least to the company match percentageAdvice #2: Understand the types of fundsTypes of Mutual FundsIndex FundTargets assets from a specific market indexEx: the S&P 500 Index targets 500 of the largest firms in the US economyFully diversifiedGrowth FundTargets firms with growth potential (aggressive, mid cap, small cap)Riskier than an Index Fund but makes good returns over timeInternational FundTargets firms in various geographic locationsFully diversifiedIncome FundTargets stocks, bonds, and REInvest in this when looking for a steady cash flow or incomeLower risk, lower returnFavored retireesSector FundTargets firms within a certain industryEx: REIT, technology, healthcare, energyNot diversifiedBe careful because if an industry tanks, your fund will tank2 Mutual Fund Keys:Load or No LoadLoad has a participation fee of 2%-7%Can be negotiatedPortfolio turnover or Management FeesFund managers make trades within the fundsThe higher the number of trades, the higher the commissionVanguard and Fidelity have no load or fees ................
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