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FIN 301 PSU Final Exam
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Terms in this set (59)
3 Step Approach to DCF Valuation
1. Develop set of expected cash flows
2. Estimate the discount rate and calculate discount factors
3. Multiply cash flows by discount factors and add them to determine value of asset
Decision Rule of Assets
If value of asset > price; buy it
If value of asset < price; sell it
Cash inflows
Revenues coming into company as a result of the project
Cash outflows
Expenses spent by company as a result of the project
Bonds
Payable from taxes from the US government or general revenues of a corporation
Stocks
Represent ownership interest in a corporation
Capital Budgeting
Process of planning and managing a firm's long term investment
Net Present Value
Difference between the value of an investment and it's cost
NPV rule
Invest in projects if the NPV of project is positive and do not invest if NPV is negative
Internal Rate of Return
Rate of return expected to be earned on a project
IRR Rule
If investment has an IRR higher than a predetermined rate of return, accept the investment
Payback Period
Length of time for the return on an investment to cover the cost of investment
Payback rule
Accept investment is payback period is less than a predetermined number of years
Profitability Index Formula
NPV / cost
NPV formula
PV - cost
Theory of efficient capital markets
1. Stock market efficient
2. Current stock prices reflect all public available info
3. Prices react instantaneously to new info
Asset diversification
Reduce the risk of portfolio by spreading wealth among a number of different investments
Reduces unsystematic risk
Total Risk Formula
Systematic risk + Unsystematic Risk
Capital Asset Pricing Model
Model that estimates rate of return an investor should expect to receive on a risky asset
Expected return on an asset Formula
Rf + B [E(Rm) - Rf]
Risk premium
Amount by which an investment is expected to outperform T-Bills
Risk premium Formula
Rm- Rf
Alpha
Measures performance
Positive alpha is good; Negative alpha is bad
Alpha formula
Observed return of asset - Expected return of asset
Unsystematic Risk
Firm specific risk that can be diversified away
Systematic Risk
Market related risk measured by Beta that cannot be diversified away
Efficient market
All investments are accurately period, no good or bad investments
Random Walk Hypothesis
Future direction of stocks can't be predicted solely on the basis of past movements
Fama and French Study
Compares performance of the returns associated with portfolios of stocks that have certain similar characteristics
Showed portfolios with a high book value to market value ratio outperformed ones with low ratios
Fixed Rate Structure
Interest rates and coupon payments are fixed over the life of the bond
Fixed Rate Par Bond
Issuer issues the bond at par value and pays fixed interest semi annually on predetermined dates and repays full par value of bond on maturity
Discount Bond
Market yield > Bond's Coupon
Premium Bond
Market yield < Bond's Coupon
Default Risk
Risk that bond will not pay interest or principal when due
Reinvestment risk
Unknown rate at which cash inflows may be reinvested
Prepayment risk
When an issuer calls a bond prior to it's maturity
Interest rate risk
Risk that a change in market interest rates will affect the value of the bond
Spread to Treasuries
Difference between yield on a non-callable US Treasury Bond and yield on a non-callable corporate bond with an identical maturity
Price validity of Bond
Extent to which price changes with fluctuations in market levels of interest rates
Municipal Bonds
Debt instruments issued by states, cities, municipal authorities and other entities
Municipal bond Interest Income
Exempt from federal and certain state and local income taxation
Yield curve
AKA term structure of interest rates
Describes relationship between yield on a security and it's maturity
Bond Yield Formula
Rf + Spread to Treasuries + Bond Specific spread
Relationship between profits and market value
Direct relationship
Relationship between interest rates and market value
Inverse relationship
Technical Analysis
Belief that stock prices are influenced more by investor psychology and emotions of crowd than by changes in fundamentals of company
Fundamental Analysis
Company's current and future operating and financial performance determine value of the company stock
Target Stock price technique
Forecasts earnings per share of a firm and multiplies EPS by projects P/E ratio to arrive at a target stock price
DCF Valuation
Stocks value is the sum of the expected cash flows of the company
Discounted at an appropriate interest rate
Dividend Discount Model
Analyst estimates future dividend growth and the required rate of return on the stock and discounts those expected dividends to arrive at a stock's value
Modern Portfolio Theory
Belief that stock prices always reflect intrinsic value and that an type of fundamental or technical a lysis is already embedded in the stock price
Ways to Reduce Risk
1. Diversification
2. Hedging
3. Insurance
4. Sell assets
Hedging
By using techniques to lock-in a price of return
Strike price
AKA exercise price
Predetermined
Expiration date
After which option can no longer be exercised
Call option
Contracts enable the owner to buy an asset
Put option
Contracts enable the owner to sell an asset
Intrinsic Value
Amount the option is in the money
Difference between the current price and the strike price of the option
Time Value
Reflects expectations of an options profitability associated with exercising it at some future point in time
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