Public Enterprise Management Ch16. Advanced financial management — portfolio, options, capital bu...
1. Portfolio Theory
Risk Types
| Type | Description |
|---|---|
| Systematic Risk (Market Risk) | Undiversifiable — Economic fluctuations, interest rates, exchange rates |
| Unsystematic Risk (Idiosyncratic Risk) | Diversifiable — Firm-specific risks |
Portfolio Effect: Combining assets with low correlation → Unsystematic risk can be eliminated.
Markowitz Efficient Frontier: The set of portfolios that minimize risk for a given level of return. Investors choose portfolios only on this line.
CAPM (Capital Asset Pricing Model)
Formula: E(Ri) = Rf + βi × [E(Rm) − Rf]
- Rf: Risk-free rate (Government bond yield)
- E(Rm): Expected return of the overall market
- βi: Asset i’s beta (Sensitivity relative to the market)
- [E(Rm) − Rf]: Market risk premium
Interpretation of Beta (β)
- β = 1: Moves in tandem with the market
- β > 1: More volatile than the market (Aggressive investment)
- β < 1: Less volatile than the market (Defensive investment)
- β = 0: Uncorrelated with the market (Risk-free asset)
SML (Security Market Line)
A graphical representation of CAPM. Above SML = Undervalued, Below SML = Overvalued.
2. EMH (Efficient Market Hypothesis)
Proposed by Fama. The theory that market prices already reflect all available information.
| Form | Reflected Information | Excess Return Possible? |
|---|---|---|
| Weak Form | Past price information | Technical analysis impossible |
| Semi-Strong Form | All public information | Fundamental analysis impossible |
| Strong Form | Including insider information | Any analysis impossible |
3. Options
Call Option: The right to buy an underlying asset. Purchased when a price increase is expected. Put Option: The right to sell an underlying asset. Purchased when a price decrease is expected.
| Call Option Buyer | Put Option Buyer | |
|---|---|---|
| Exercise Condition | Market Price > Strike Price | Market Price < Strike Price |
| Maximum Loss | Premium | Premium |
| Maximum Profit | Theoretically infinite | Strike Price − 0 |
Put-Call Parity: The relationship between puts and calls with the same underlying asset and strike price. Prevents arbitrage opportunities.
Option Value Determinants (Black-Scholes)
Underlying asset price / Strike price / Time to maturity / Volatility / Risk-free rate / Dividend
4. Capital Budgeting
Evaluating the economic feasibility of long-term investment projects.
NPV (Net Present Value)
NPV = Σ [CFt / (1+r)t] − Initial Investment
- NPV > 0: Worth investing ✓
- NPV = 0: Minimum required rate of return met
- NPV < 0: Reject investment ✗
Advantages: Considers the time value of money, expresses absolute monetary amounts.
IRR (Internal Rate of Return)
The discount rate that makes NPV = 0. Accept investment if IRR > Cost of capital.
When NPV vs IRR Conflict: Prioritize the NPV method. (Due to scale differences and reinvestment assumption differences)
Payback Period
The time required to recover the initial investment through cash flows.
Advantages: Simple, reflects liquidity risk. Disadvantages: Ignores the time value of money, ignores cash flows after payback.
Discounted Payback Period: Payback period reflecting the time value of money.
PI (Profitability Index)
PI = Present value of cash flows / Initial investment. Accept if PI > 1.
5. Capital Structure Theory
MM Theory (Modigliani-Miller)
MM Proposition I (No Tax): Capital structure is irrelevant to firm value. MM Proposition II: Increase in debt → Shareholders’ required rate of return increases (reflecting higher risk). MM with Taxes: Tax shield effect of debt interest → Increase in debt increases value.
Optimal Capital Structure
- Increase in debt → Tax shield benefits vs. Increased financial distress costs
- Equilibrium point = Optimal capital structure (Trade-off Theory)
Core Summary (Frequently Tested Keywords)
| Keyword | Related Theory |
|---|---|
| CAPM | E(R) = Rf + β×(Rm−Rf) |
| Beta (β) | Risk sensitivity relative to the market |
| EMH | Weak, Semi-strong, and Strong forms |
| Call/Put Option | Right to buy / Right to sell |
| NPV | Net present value, accept if NPV > 0 |
| IRR | Discount rate where NPV = 0 |
| MM Theory | Capital structure irrelevance |
| Tax Shield | Debt interest tax savings effect |
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