Chapter 3 Flashcards
(27 cards)
Valuation Principle
Value of an asset to the firm or its investors is determined by its competitive market price.
The benefits/costs of a decision should be evaluated using these market prices and when the benefit exceed the costs the decision will increase the market value of the firm
Competitive market
A market in which a good can be bought and sold at the same price
Time value of money
Difference in the value of money today and in the future
Risk free interest rate
The interest rate at which money can be borrowed or lent without any risk over that period
Interest rate factor
1 + rf = $s value today / $value in one year
PV of an investment
Expressing the value in terms of dollar today
PV = FV / (1 + r)^n
FV of an investment
Expressing the value in terms of dollars in the future
FV = PV x (1 +r)^n
Discount factor
1 / 1 + r
NPV
PV (Benefits) - PV (Costs) = PV (all project cash flows)
NPV Decision Rule
When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.
Accept projects with
Positive NPV
Reject projects with
Negative NPV
Arbitrage
The practice of buying and selling equivalent goods in different markets to take advantage of a price difference
Arbitrage opportunity
An opportunity to buy in the cheapest market and resell in a higher priced market
–> Because an arbitrage opportunity has a positive NPV, investors will race to take advantage of it
–> Those investors who spot the opportunity first and who can trade quickly will have the ability to exploit it.
Normal market
A competitive market in which there are no arbitrage opportunities
Law of One Price
If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in all markets
Financial security (or security)
An investment opportunity that trades in a financial market
Bond
A security sold by governments and corporations to raise money from investors today in exchange for the promised future payment.
Short sale
Practice of borrowing a security from someone who has it already with the intent to sell it and gain profit
Price (Security) =
PV (All cash flows paid by the security)
Risk free interest equals
Percentage gain that you earn from investing in the bond –> RETURN
Return = Gain at End of Year / Initial Cost
If there is no arbitrage, the RFR is =
TO THE RETURN FROM INVESTING IN A RISK FREE BOND
If the bond has a lower return than the RFR
INVESTORS WOULD SELL THE BOND AND INVEST THE PROCEEDS AT THE RISK FREE INTEREST RATE
If the bond has a higher return than the RFR
INVESTORS WOULD EARN A PROFIT BY BORROWING AT THE RISK FREE INTEREST RATE AND INVESTING IN THE BOND
