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Fin 301 Final Exam !!!
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Terms in this set (67)
Discount
Multiply a number by less than one.
Discount rate
A function of time and risk: discount rate=f(time,risk)
Discount factor
A function of both time and the discount rate: [discount rate=f(time,discount)]
Present value
of an investment is the sum of the expected cash flows multiplied by their respective discount rate.
Three-Step Approach [DCF Valuation]
1. Develop a set of expected cash flows.
2. Estimate the discount rate and calculate the discount factors.
3. Multiply the cash flows by the discount factors and add them to determine the value of the asset.
Decision Rule
Value > Price : Buy!
Value < Price : Sell!
Project/Venture
An investment to produce a product or provide a service that will generate money in the future.
Cash Inflows
-Additional revenues coming into the company as a result of the project.
-Consist of dividends and increase/decrease in stock price.
Cash Outflows
Additional expenses being spent by the company as a result of the project.
Bond
-A debt instrument.
-Corporations, the US Government, and municipalities issue bonds.
-Payable from taxes from US government or the general revenues of a corporation.
Cash inflows to an investor
Bond interest payments, usually every 6 months, and repayment of principal.
Stock
Represents ownership interest in a corporation.
Life of stock
Infinite. There is no maturity associated with a stock.
Risk of a stock
Hard to quantify, making it difficult to determine the proper discounting rate.
Capital budgeting
-The process of planning and managing a firm's long-term investment in projects and ventures.
-Estimating the amount, timing and risk of future cash flows.
-Starts with estimation of incremental cash flows from a project; creating a time line of expected cash flows; and comparing the value of the cash flows to the cost of project.
Net Present Value [NPV]
-The difference between the value of an investment and its cost.
-The value of any project, venture or investment is equal to the present value of its expected cash flows, discounted for their risk and timing.
NPV Rule
NPV, Positive : Invest!
NPV, Negative : Do not invest!
Internal Rate of Return [IRR]
-The rate of return that is expected to be earned on a project.
-The discounting rate that makes the net present value of an investment equal to zero.
IRR Rule
IRR > predetermined required rate of return : Accept!
IRR > predetermined required rate of return : Reject!
Payback Period
-The length of time for the return on an investment to cover the cost of the investment.
-Calculation involves only gross cash flows and not discounted cash flows.
Payback Rule
Payback period < Predetermined no of years : Accept!
Payback period > Predetermined no of years : Reject!
Profitability Index
Accept project with highest Profitability Index
Risk (Low --> High)
T-Bills -> Gov Bonds -> Corporate Bonds -> Low risk Stock -> Market Portfolio -> High risk Stock
Efficient Capital Market [ECM]
-Stock market is brutally efficient.
-Current stock prices reflect all publicly available information
-Stock prices react completely, correctly and almost instantaneously to incorporate the receipt of new information
If stock market is efficient...
It would be useless to forecast future prices by technical analysis and fundamental analysis.
Calculation of simple averages
-If there is a negative percentage, biased upwards
-Simple average returns can hide very poor performance
Asset diversification will reduce risk
-Spread your wealth among a number of different investments.
-The goal is to invest in a group of assets that provides you with the best return possible given a level of risk.
-Reduce the unsystematic risk of a portfolio
Correlation coefficient
- +1.0 : when one stock is up 10%, the other stock go up 10%
- -1.0 : when one stock is up 5%, the other stock is down 5%
- Assets that are highly correlated offer less risk reduction from diversification than assets that are less correlated.
Unsystematic Risk
-Specific to a company.
-The risk that can be diversified away.
Systematic Risk
-Market related risk as measured by Beta.
-Can not be diversified away.
Capital Asset Pricing Model [CAPM]
-A simple model that estimates the rate of return an investor should expect to receive on a risky asset.
-Determine the discount rate to use when valuing an asset.
-Expected return of a risky asset(common stock) = return on the risk-free asset plus a risk premium
-Estimate the cost of equity, the most significant component of a company's weighted cost of capital.
Risk Premium
The amount by which an investment is expected to outperform T-Bills or the average amount by which an investment has outperformed T-Bills in the past.
Alpha
-Measures performance.
-Positive alpha is good, Negative alpha is not so good.
-Observed Return of Asset - the risk that can be diversified away
Beta
Risk
Efficient Market
-A market where all investments are accurately priced.
-There are no good or bad investments.
-Each investment offers an expected return to match its level of risk.
If a market is efficient...
all investments lie of the risk-expected return line.
Random Walk Hypothesis
-A path that a variable takes, such as the observed price of a stock, where the future direction of the path can't be predicted solely on the basis of past movements.
-Share prices react immediately to news so that there is no predictable trend implied by a more gradual share price adjustment.
The Fama and French Study
-Compares the performance of the returns associated with portfolios of stocks that have certain similar characteristics.
-Study showed, among other things, portfolios of stock with a high book value(BE) to market value(ME) ratio consistently outperformed portfolios with low(BE/ME) ratios and called to question the validity of efficient capital markets.
Fixed rate structures
-The interest rates and coupon payments are fixed over the life of the bond, and the investors and the issuer are certain of the payments.
Fixed rate par bond
The issuer issues the bond at par value(100%) and pays fixed interest semi annually on predetermined dates and repays the full pay value of the bond on maturity.
Market yield
Bond coupon
Discount bond
Market yield greater than bond's coupon
Premium bond
Market yield less than bond's coupon
Four types of Risk
1.Default risk
2.Reinvestment risk
3.Prepayment risk
4.Interest rate risk
Default risk
The risk that bond will not pay interest or principal when due
Reinvestment risk
The unknown rate at which cash inflows may be reinvested.
Prepayment risk
-When an issuer calls a bond prior to its maturity.
-The call options and redemption features in debt instruments introduce uncertainty into the expected cash flows.
Interest rate risk
-The risk that a change in market interest rates will affect the value of the bond.
-Price volatility of a bond is the extent to which its price changes with fluctuations in market levels of interest rates
Spread of Treasuries
-Difference between the yield on a non-callable US Treasury bond and the yield on a non-callable corporate bond with an identical maturity.
-Measure of the default premium associated with the corporate bond.
-A function of the type of industry the issuer belongs, the credit rating of the corporate bond and a function of the rime to maturity of the bond.
Bond prices and yields...
move in opposite directions, other things being equal.
Municipal bonds
-Debt instruments issued by states, cities, municipal authorities and other entities.
-Interest income are exempt from federal and certain state and local income taxation.
-Huge, diverse and extremely complicated marketplace.
Yield curve
AKA the term structure of interest rates, describes the relationship between the yield on a security and its maturity.
Shape of yield curve
Depending on the rate of inflation or deflation, the economy and monetary policies
-Upward sloping:most common
-Downward sloping:a significant slowdown in inflation is anticipated, flat or humped.
Valuing a Bond
1. Bond prices and changes in interest rates move in opposite directions.
2. Investors and traders value and bonds based on a price to worst call feature scenario.
Common stock
Represents a proportionate ownership interest in a corporation.
Value of a stock
Dependent upon the future profits or cash flows that the firm is expected to generate and the interest rate or required yield level that is expected from the investment.
Direct relationship
Higher profits increase a stock's market value and lower profits decrease its value
Inverse relationship
Higher interest rates decrease market value and lower yields and interest rates increase value.
Dividen policy
-Should not affect the current value of a stock.
-Affect the expected future value of a stock greatly
Technical Analysis
-Believe that stock prices are influenced more by investor psychology and emotions of the crowd than by changes in the fundamentals of the company.
-Chart historic price movements, volume of trading activity, and the price/volume aspects of related equity and debt markets to predict or anticipate the stock buying behavior of other market participants.
-Have shorter-term stock holding orientation and more frequent trading activity.
Fundamental Analysis
-The company's current and future operating and financial performance determine the value of the company's stock.
-Company's stock has a true or intrinsic value to which its price is anchored.
-To assess a company's prospects, evaluate overall economic, industry and company data to estimate a stock's value.
Modern Portfolio Theory
-Efficient capital markets is a cornerstone of MPT and is the belief that stock prices always reflect intrinsic value, and that any type of fundamental or technical analysis is already embedded in the stock price.
Ways to reduce risk associated with financing assets
1.Diversification - spread the risk by investing in a number of risky assets.
2.Hedging - using techniques to lock-in a price of return.
3.Insurance - pay a premium to purchase a contract to protect
4.Sell the assets
Insurance-option
1.Strike price - aka exercise price, predetermined
2.Expiration date - the option can no longer be exercised
3.Call option - contracts enable the owner to buy asset
4.Put option - contracts enable the owner to sell asset
Value of Option
1.Intrinsic value
2.Time value
Intrinsic value
The amount the option is in the money and is the difference between the current price and the strike price of the option
Time value
Reflects expectations of an option's profitability associated with exercising it at some future point in time.
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