Streetbites from the media perspective
Mutual fund categories
Streetbites from the media perspective
 Mutual funds buy securities throughout many facets of company
industries or categories
 See textbook page 429 - 431 for related content on this topic.
Videos for Module 10, Unit 2-of-2
What is a mutual fund - categories (6:00)
What is the ultimate mark-to-market book value? Visit
http://www.investorwords.com/3236/Net_Asset_Value.html
TABLE 9.8 Summary of mutual fund categories.
Notable risk and
Types of financial securities
return characteristics
that the mutual fund owns
-1-21. Money market mutual funds
These funds own short-term credit market
Risk of losing principal is securities issued by U.S. corporations and
nil. Rates of return are
federal, state and local governments and
relatively low and follow their agencies. The interest income that the
movements in short-term fund receives generally is taxable income to
interest rates.
investors.
2. Bond mutual funds
Risk of losing principal
2a. Taxable bond funds
depends on two
These funds own short or long-term credit
separate traits: quality market securities issued by U.S. corporations
and term. The lowest and federal, state and local governments and
quality are junk bond their agencies. The interest income that the
funds which may have fund receives generally is taxable income to
high risk. High quality
investors.
bond funds have lower
risk. Long-term bond
2b. Tax-exempt bond funds
funds have higher risk of These funds own credit market securities
sharp price declines;
called “municipal bonds.” Investors do not
short-term bonds funds pay federal taxes on interest from municipal
have less price risk.
bonds (state tax liability depends on details).
Bond fund rates of
The tax-exempt interest rate, all else equal, is
return: (1) have a long- less than the taxable interest rate. Municipal
run average that is larger bonds presumably finance public goods such
than money market but
as schools, hospitals, and transportation
smaller than equity
projects. There are two types of municipal
funds; (2) move inversely
bonds. Repayment of “revenue bonds”
with interest rates.
depends on cash flows that the project
Falling interest rates generates. Repayment of “general obligation
push up the returns for bonds” depends on the creditworthiness of
existing bond fund
the government organization that sponsors
investors, especially
the issue.
long-term bonds.
Lessons about the Structure of Finance
3. Equity mutual funds
3a. Index funds; ETFs leverage & invert!!
The objective of equity index mutual funds is
to closely match the movement in an
underlying stock index, such as the S&P500,
or Dow Jones Industrial Average, etc. The
funds do not promise to pick great stocks,
they simply promise to track the target index.
3b. Growth funds
The objective for managers of equity growth
funds is identification of companies with
strong sales, asset, and/or profit growth.
Risks generally are
higher for equity mutual
3c. Value funds
funds than for bond
The objective for managers of equity value
mutual funds. Equity
funds is identification of stocks that appear
mutual fund risk reflects
undervalued relative to peers.
component security risks
although the fund
3d. Income funds
realizes diversification The objective for managers of equity income
benefits. Foreign equity funds is identification of companies that pay
investment introduces
relatively large dividends.
additional risks. Longrun average rates of
3e. Sector funds
return are higher for The prospectus sometimes restricts an equity
equity mutual funds than mutual fund to buy stocks for companies
any other category.
satisfying a criterion. The criterion usually
describes a specific market sector. Common
criteria include (1) line of business, for
example, biomedical mutual fund versus
telecommunications fund; (2) company size,
for example, small versus large market
capitalization company; (3) geographical, for
example, U.S.A. companies versus European
companies versus Latin American
companies; (4) economic backdrop, for
example “emerging economies” versus
“developed nation status”.
4. Balanced mutual funds
Risk of loss usually is
less for a balanced fund A balanced mutual fund diversifies broadly
than for a pure equity
across many types of both bonds and
fund. Returns tend to be
equities.
less volatile, too.
Lessons about the Structure of Finance
5. Real estate mutual funds
The objective for managers of real estate
mutual funds is identification of prime
commercial properties that promise relatively
Risk of loss usually is
high rental incomes and opportunities for
less for a real estate
price appreciation. These “real estate
fund than for a pure
investment trusts (REITs)” are subject to
equity fund. Returns
different regulations because the asset side
tend to be less volatile,
of the balance sheet contains bricks-andtoo.
mortar as well as financial securities.
Project specific financing needs (SIVs)
motivate the parade of names of special
investment vehicles in the credits preceding
most movies we watch.
TABLE 9.8 Summary of mutual fund categories.
Lessons about the Structure of Finance
Chapter 11, Unit 2 of 2
The company cost of capital
Lessons about the Structure of Finance
 The discount rate for a company to evaluate investments
opportunities is the company cost of capital.
 See textbook pages 537 - 551 for relevant readings.
Videos for Module 10, Unit 2-of-2
What is a mutual fund - categories (6:00)
Compare 2 risk premia using CML (12:10) [Example 3]
Find effect of a CAPM shock on intrinsic value (9:47) [AP8]
Beta and the CAPM (13:33) [AP4A]
Security market line (3:31)
Estimating beta (6:00) [AP2a]
Market model and risk-adjusted ROR (6:04) [AP2d]
The company cost of capital (6:47)
Computing the WACC (5:53) [CC1]
Find WACC and NPV (7:40) [CC2]
TR14 compare systematic and unsystematic risk
Two stocks, A and B, possess the following characteristics.
On average high risk gets high return but only the risk that cannot be diversified away to
nothingness gets the probable return.
beta
standard deviation
stock A
1.08
0.12
stock B
1.00
0.18
When idiosyncratic risk is perfectly diversifiable then which statement about the security risk
premium is most accurate?
a. stock B has the highest required risk premium because it has the least idiosyncratic risk
b. stock B has the highest required risk premium because its standard deviation is largest
c. stock B has the highest required risk premium because its total risk is largest
d. stock A has the highest required risk premium because its beta is largest
e. stock A has the highest required risk premium because it has the most idiosyncratic risk
Lessons about the Structure of Finance
TR12 Which CAPM concept is correct
Which statement about important concepts in the Capital Asset Pricing Model is most accurate?
a. the security market line passes through two points with coordinates (beta, rate of
return) equal to (0, risk-free rate) and (1, expected market return)
b. the efficient frontier passes through two points with coordinates (standard deviation, rate of
return) equal to (0, risk-free rate) and (market standard deviation, expected market return)
c. the capital market line is the risk-return profile that contains the set of all dominant portfolios
comprised possibly of all securities
d. the security market line passes through two points with coordinates (standard deviation, rate
of return) equal to (0, risk-free rate) and (market standard deviation, expected market return)
e. the efficient frontier passes through two points with coordinates (beta, rate of return) equal to
(0, risk-free rate) and (1, expected market return)
EXERCISES 11.3
8. You have the following information about equity rates of returns for the past 5
periods.
company ROR
market ROR
obs 1
19%
15%
obs 2
15%
15%
obs 3
-2%
-6%
obs 4
18%
20%
obs 5
8%
11%
8a. Based on the above observations, what is the company’s ? AP2a .
8b. The most recent information suggests that the current period market return is -7%
and the security return is 5%. Use the market model to find the company risk-adjusted
rate of return? AP2d .
ANSWER 8a. Use the DATA and STAT functions on the calculator to find that “b =
0.8259.” The beta equals 0.8259. Notice as an aside that the calculator also displays
σx = 8.97% (that equals market standard deviation σM), σy = 7.81% (that equals security
standard deviation σA), and r = 0.95 (that is the correlation ρA,M). Use these numbers
and verify that formula 11.5a also computes that β = 0.83. The number on the display
for “a = 2.5154” is the intercept (alpha) for the regression and appears below.
8b. Easily compute this answer by following the Calculator clue in the text. Find
from the calculator that alpha = 2.5154, beta = 0.8259, and compute that when the
market return is –7% the security equilibrium return is –3.2% [= 2.5154 + (0.8259 × risk-adjusted
7%)]. Compute with formula 11.6 that ROR
equals 8.27% [= 5% – (-3.27%)].
DEFINITION 11.3 Company cost of capital
The company cost of capital is the discount rate for computing net present value of company investment
opportunities.
FORMULA 11.7 Weighted average cost of capital ROR
wacc
The discount rate appropriate for assessing net present value of investment
opportunities for company A equals a weighted average of debt and equity financing
wacc
rates. Compute that discount rate, denoted RORA
, as follows:
Lessons about the Structure of Finance
tax 


ROR Aw acc  w debt i A 1 
 rate 
 w equity ROR Arequired .
Weights wdebt and wequity sum to 100% and measure the proportion of existing long-term
financing provided by debt and equity. The pretax interest rate iA is the yield-to-maturity
wacc
on company long-term debt. RORA
applies to any capital investment for company A
irrespective of actual financing method for that specific project.
Public utilities companies often justify pricing policies by documenting the
weighted average cost of capital to state regulatory commissions. The snippet
below from table 2.1 shows the biggest electric power holding company in the list
of 11,000 U.S. companies circa beginning of year 2014.
Ticker
Symbol
AFL
COP
RF
DUK
BAM
GOOG
Total Assets
$millions
$121,307
$118,057
$117,396
$114,779
$112,745
$110,920
Employees
Thousands
Net Income (Loss)
$millions
Sales/Turnover (Net)
$millions
Market Capitalization
$millions
9
18
24
28
28
48
$3,158
9,156
1,122
2,665
2,120
12,920
$23,939
54,413
5,602
24,549
20,166
59,825
$ 30,689
86,613
13,626
48,721
23,899
376,370
SNIPPET from table 2.1 in chapter 2: DUK
Duke Energy Corp. (DUK, 4th row at rank 61 in table 2.1) gained the distinction of nation’s
largest electric utility after takeover of Progress Energy Inc in 2012. When the takeover closed
DUK executed a 1-for-3 reverse stock split. With a 1-for-3 reverse stock split, shareholders got
one DUK share for every three DUK shares they already owned. The market determined stock
price for each share approximately tripled so that the overall market cap and portfolio values
remained the same. In late 2013 the DUK management finalized a rate case settlement
agreement with the South Carolina Office of Regulatory Staff request for its Carolinas electricity
company to raise customer rates by 5.53 percent the first year ($220 million, DUK requested
15.1 percent). The settlement approved the DUK RORWACC with weights of 53 percent on debt,
47 percent on equity, and a cost of equity of 10.2 percent. Had the Commission settled on 8.5
percent, according to news reports, then customer rates would not have risen at all. 170 basis
points was worth $220 million in this case. The financial contracting between a nonfinancial
corporation like DUK and its inflow stream from customers relies on measures that must be
made for sound financial management and public finance decisions to occur.
EXERCISES 11.4
1. The company is evaluating profitability of a long-term investment opportunity. Their
balance sheet shows that 65% of long term financing relies on debt at a 8.5% pretax
interest rate. The other 35% is Stockholders equity. The company marginal tax rate is
34%. Statistical estimates find that company β is 0.85. The short-term risk-free rate
currently is 5% and the company believes that the required risk premium for the market
Lessons about the Structure of Finance
portfolio is 7.5%. Find the company’s weighted average cost of capital appropriate for
computing net present value of investment opportunities. CC1 nxq
required
ANSWER Use formula 11.5b to find ROR
is 11.375% [= 5% + 0.85 (7.5%)].
Now substitute all numbers into formula 11.7 and compute the WACC is 7.63% [= 0.65
× 8.5% × (1 – 0.34) + 0.35 × 11.375%].
CC2 Find NPV of perpetual savings
A company pursues a cost-cutting initiative that costs $29,000 to implement.
Thereafter, however, the initiative reduces after-tax costs by $5,000 per year
perpetually. The company relies on 58% debt financing at a 12.1% pretax interest rate.
The company marginal tax rate is 27%. The company β is 0.86, short-term risk-free
rate is 8.1%, and required risk premium for the market portfolio is 11.0%. Find the
project’s net present value.
ANSWER: E ; CLUES: RORrequired = 17.6% ; WACC = 12.50%
a. $13,316
b. $14,648
c. $16,113
d. $12,106
e. $11,005
Lessons about the Structure of Finance