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Modigliani-Miller Tax Model (formula)

Re = Ro + (Ro – Rd)(1 – tax rate)(Debt/Equity)

Ro = cost of all equity company

Re = cost of equity for the firm

Rd = cost of debt for the firm

Solve for the variable you do not have.

A dividend policy that pays a fixed percentage of earnings is…

Constant Dividend Payout Policy

For any bond in which expected future spot rates are higher than a quoted forward rate for the same maturity as implied by the current spot curve, the bond is ____

Overvalued

vs. its intrinsic value since the market is placing a lower discount rate on its cash flows.

The assumptions under the Arbitrage Pricing Theory are:

  1. A factor model describes asset returns.
  2. There are many assets, so investors can form well-diversified portfolios that eliminate asset-specific risk, not factor risk.
  3. No arbitrage opportunities exist among well-diversified portfolios.

Adjusted R^2 adjusts for:

the loss of degrees of freedom when additional independents variables are added to a regression.

If the (Engle-Granger) Dickey-Fuller test rejects the null hypothesis that the error term has a unit root then the conclusion is:

that the error term in the regression is covariance stationary. Therefore the two time series are cointegrated.

The parameters and standard errors from linear regression will be consistent and will allow testing of the hypotheses about the long-term relationships between the two series.

 

Major differences between assumptions for the Structural Model and Reduced Form Model?

Structural Model Reduced Form Model
  • Balance sheet is simple with only one class of zero coupon bond.
  • Asset is actively traded in the market.
  • Risk-free rate is constant.
  • There is a zero coupon bond traded in the market.
  • Risk-free rate is stochastic.
  • Default risk depends on the economic conditions.

ROCE is essentially ROIC before…

TAX

and is defined as operating profit divided by capital employed

ROCE is useful when comparing peer companies in different countries because the comparison of underlying profitability would not be skewed by low taxes.

Capitalization Rate (formula)

Capitalization Rate = WACC – Long term Growth Rate

Does CAPM incorporate company specific risk?

No