Financial Management (21%) Flashcards
(134 cards)
A cost that has been incurred in the past, cannot be changed by current decisions, and is irrelevant to making current and future replacement decisions.
SUNK cost (i.e. original cost of machine and related accumulated depreciation)
Another way to say Cost of Capital
Rate of Return, companies will always seek to minimize the required rate of return (cost of capital) needed to attract shareholder investment in the corporation.
Opportunity Cost Defined
Opportunity cost is the discounted dollar value of benefits lost from an opportunity as a result of choosing another opportunity.
Remember that the gain on sale of the old item will be rolled into the disposal cost and is a SUNK cost.
Incremental Cost Defined
Incremental costs are those that are different between two or more alternatives under consideration. Remember that fixed costs are present regardless of which option is chosen and should not be considered when calculating incremental/differential cost.
Definition of Ordinary Annuity and Ordinary Annuity Due
OA = equal payments made at the end of each period.
OAD = equal payments made at the beginning of each period.
Present Value vs. Future Value
For present value, the higher the interest or discount rate, the lower the present value of a future amount. Since the higher the interest or discount rate, the more that is counted as interest, the less there is in present value.
For future value, the higher the interest rate, the greater the future value of a present amount. Since future value is computed as principal plus compounded interest, the higher the interest rate, the greater the amount of interest earned each period and, therefore, the greater the accumulated future amount.
Stated Interest Rate (nominal rate) and Real Interest Rate
What is difference between Real Interest Rate and Real Risk Free Interest Rate?
The stated interest rate (also called the nominal or quoted interest rate) is the annual rate specified in the loan agreement or comparable contract; it does not take into account the compounding effects of frequency of payments or the effects of inflation.
Real interest rate—as contrasted with nominal interest rate, refers to the rate of interest after taking into account the effects of inflation on the value of funds received. The calculation of the real interest rate (RIR) is: RIR = Nominal int. rate - inflation rate
The Real Risk Free Rate is the basic component of interest or another way of saying nominal.
Simple Interest and Compound Interest
Original principal only; no compounding in the interest computation.
Compound interest provides that interest be paid not only on the principal, but also on any amount of accumulated unpaid interest. Compound interest pays interest on interest; simple interest does not.
Compound Interest Formula (same as Future Value of $1 formula)
Compound interest and future value of $1.00 calculations are performed in the same manner. Both account for interest being paid on accumulated interest. For multiple period calculations either the formula above or a future value of $1.00 table can be used.
If asked to calculate the CI, formula attached with facts below.
- P = principal amount (the initial amount you borrow or deposit)
- r = annual rate of interest (as a decimal)
- t = number of years the amount is deposited or borrowed for.
- A = amount of money accumulated after n years, including interest.
- n = number of times the interest is compounded per year
Effective Interest Rate
The effective interest rate is determined as the full cost of a loan divided by the net cash proceeds.
Remember in calculating the proceeds, take into account the discount if any, compensating balances, origination fees etc.
Interest Cost = P x R x T EIR = (Int. Cost / P) / T
Annual Percentage Rate (APR)
One step past EIR, The annual percentage rate of interest is the annualized rate for a loan that is for less than a full year. NO COMPOUNDING
I = P x R x T (where T is length of loan, i.e. 1 quarter is 90/360)
going off example above, the APR is EIR x 4 for the full year APR.
Effective APR
The EAPR will always be higher than the APR due to compounding. The EAPR, also called the annual percentage yield, is the APR with compounding on loans that are for a fraction of a year.
As discussed under compounding, the assumption is that interest is paid on interest that would accumulate for each period during the year.
The formula for computing the effective annual percentage rate (EAPR) is: (1+I/P) P − 1
“2/10, net 30” Defined
Credit terms of “2/10, net 30” mean that the debtor may take a 2% discount from the amount owed if payment is made within 10 days of the bill, otherwise the full amount is due within 30 days.
The 2% discount is the interest rate for the period between the 10th day and the 30th day; it is not the effective annual rate of interest.
GAAP Fair value is…
Price received to SELL an asset or paid to transfer a liability. It is NOT an entry price.
U.S. GAAP Fair Value Hierarchy of Inputs
- Level 1 = highest quality inputs (unadjusted quoted prices for identical item in active market)
- Level 2 (quoted prices for similar (not identical) item in active market, quoted prices for identical item in non-active market)
- Level 3 = lowest quality (and typically not visible) inputs (entity assumptions and internal data)
Fair Value Framework approaches to developing FV
Market Approach
Income Approach (discounted cash flows)
Cost Approach (replacement cost)
Beta
Beta is the covariance of the asset’s returns with the returns of the overall portfolio. Therefore, it measures the systematic risk of the investment. Measure of volatility of an asset when compared to a benchmark for a whole class of that asset.
b = 1, asset moves in line with benchmark
b > 1, asset moves more than benchmark
CAPM Assumptions and Limitations
- Assumes there is both an asset class and benchmark for asset being valued.
- Assumes all investors have equal assets to all investments of class being valued and all use one time-period horizon.
- Assumes asset risk measured solely by variance of the asset being valued from asset class benchmark.
- Assumes no external cost or restrictions on borrowing.
- Uses historical data
kS (CAPM) = kRF + (kM − kRF)bi
CAPM is widely used, but primarily for:
- Securities Analysis
- Capital Budgeting
- Setting Fair Compensation for Regulating Monopolies
The risk-free rate of return is a measure of?
The time value of money.
The standard deviation of an investment’s expected return is?
A measure of its risk.
What type of risk does an investment with a beta of 1 have?
Average Systematic Risk
The riskier an investment, the higher the? What does the CAPM model truly measure?
Expected return
The capital asset pricing model (CAPM) measures the relationship between risk and reward.
Black Scholes Option Pricing Model
For Euro call options Stocks pay no dividends Stock prices increase in small increments RFR is assumed constant Uses probabilities Uses discounting