Module 43 Flashcards
(54 cards)
1
Q
EQUITY RISK PREMIUM
A
- The quity risk premium is equal to the real return on stocks minus the real return on as measured by the return on treasury bills
2
Q
AVERAGE RISK PREMIUM
A
- Calulated at the risk between common stock and bonds
3
Q
RISK ADVERSE
A
- Risk adverse does not mean investors will not take risk; it means they must be compensated for taking risk
4
Q
RISK NEUTRAL INVESTORS
A
- Investors that prefer investments with higher whether or not they have risk. These investors disregard risk.
5
Q
RISK SEEKING INVESTORS
A
- Investors that prefer to take risks and would invest in a higher risk investment despite the fact that a lower-risk investment might have the same return
6
Q
INVESTMENT RETURN
A
- Investment reurtn is the total gain or loss on an investment for a period of time.
Formula:
P 1– P +CF
P
P1 = Assets future market value
P = The Assets price
CF = Cash flows for assets
7
Q
ARITHMETIC AVERAGE RETURN
A
- A method in which to calculate expected returns.
- Computed by simply adding the historical returns for a number of periods and dividing by the number of periods
- Use for shorter periods
8
Q
GEOMETRIC AVERAGE RETURN
A
- A method in which to calculate expected returns.
- This computation depcits the compound annual return earned by an investor who bought the asset and held it for the number of historical periods examined. If returns vary through time, the geometric avg will always fall below the arithmetric avg.
- Use for longer periods
9
Q
COEFFICIENT OF VARIATION
A
- A measurement of risk, where a lower number is better (less risky)
Standard Deviation
Expected Return
10
Q
UNSYSTEMATIC RISK
A
- The risk that exists for one particular investment or a group of like investments (e.g technology stock)
11
Q
SYSTEMATIC RISK
A
- Relates to market factors that cannot be diversified away.
- Examples include fluctuations of in GDP, inflation and interest rates
12
Q
BETA
A
- A measure used to estimate an investments systematic risk
13
Q
CREDIT/DEFAULT RISK
A
- The risk that the firm will default on payment of interest or principal of the loan or bond.
- Dvided into two parts:
- Creditworthiness - risk of default
- Sector Risk - risk related to economic conditions of the firms economic sector
14
Q
INTEREST RATE RISK
A
- The risk that the value of the loan or bond will decline due to an increase in interest rates
15
Q
MARKET RISK
A
- The risk that the value of the loan or bond will decline due to a decline in the aggregate value of all the assets in the economy
16
Q
STATED INTEREST RATE
A
- The contractual rate charged by the lender
17
Q
EFFECTIVE ANNUAL INTEREST RATE
A
- True annual return to the lender
1 + Standard Annual Interest Rate
Compounded Frequency
Raised to the Compound Frequency
- 1
18
Q
YIELD CURVES
A
- Normal - upward sloping, s/t rates are < inter rates which are < l/t rates
- Inverted - downward sloping, s/t rates are > inter rates which are > l/t rates
- Flat - s/t, inter, and l/t rates are all about the same
- Humped - inter rates are > than s/t and l/t rates
19
Q
LIQUIDITY THEORY
A
- States that l/t rates should be higher becase investors have to hold less liquid and more price sensitive securities
- If interest rates increase and an investor holds a fixed-rate l/t security, the value of that security declines
20
Q
MARKET SEGMENTATION THEORY
A
- States that treasury securities are divided into market segments by the various financial institutions investing in them:
- Commercial Banks - prefer s/t securities to match their s/t lending strategies
- Savings & Loan - prefer intermediate
- Life Insurance - prefer l/t due to nature of pilicies held by investors
- Demand curve depends on what type you are
21
Q
EXPECTATION THEORY
A
- Explains yields on l/t securities as a function of s/t rates. Basically, l/t rates reflect the average of the s/t rate over the time period the security is outstanding. This is key to determining market expectations
- if l/t rates are lower than s/t you could argue that the market expects rates to fall, and inflation to decrease
22
Q
OPTIONS
A
- Allow, but do not require, the holder to buy (call) or sell (put) a specific or standard commodity or financial instrument, at a specific price during a specified period of time (american) or at a specified date (european)
23
Q
FORWARDS
A
- Negotiated contracts to purchase and sell a specified quantity of a financial instrument, foreign currency, or commodity at a price specified at origination of the contract, with delivery and payment at a specified future date
24
Q
FUTURES
A
- Forwards-based standardized contracts to take delivery of a specified financial instrument, foreign curreny, or commodity at a specified future date during a specified period generally at the then market price
- uses nice rounded numbers
25
**CURRENCY SWAPS**
- Forward based contracts in which two parties agree to exchange an obligation to pay cash flows in one curreny ffor an obligation to pay in another currency
26
**INTEREST RATE SWAPS**
- Forward based contracts in which two parties agree to swap streams of payments over a specified period of time.
- an example is one in which one party agrees to make payments at a fixed rate and the other in variable rates
27
**SWAPTION**
- An option of a swap that provides the holder with the right to enter into a swap at a specified future date with specified terms, or to extend or terminate the life of an existing swap
28
**BASIS RISK**
- The risk of loss from ineffective hedging activities
29
**HEDGING ACTIVITIES**
1. Fair Value - A hedge of the changes in the fair value of a recognized asset or liability
2. Cash Flow - A hedge in the variability in the cash flows of a recognized asset or liability
3. Fx Currency - Can either be fair value or cash flow - based on Fx commitments
30
**HEDGING ACCOUNTING**
1. Fair Value - record to earnings
2. Cash Flow - Effecitve goes to OCI. ineffective goes to earning
3. Fx Currency - based on whether its a fair value or cash flow hedge
31
**FV VALUE OF $1**
- Multiply amount invested X factor to get accumulation
32
**FV VALUE OF ORDINARY ANNUITY**
- Multiply payment X Factor to get accumulated amount
- Payments at the end of the period
33
**PRESENT VALUE OF $1**
- Multiply amount desired by X Factor to get amount you have to invest NOW.
- This is the reciprocal of FV of $1
34
**PRESENT VALUE OF ORDINARY ANNUITY**
- Multiply amount desired by X Factor to get amount you have to invest NOW to provide those payments
35
**ORDINARY ANNUITY VS. ANNUITY DUE**
- Ordinary annuity payments made at end, annuity due payments are made at the beginning
- Change from Ord to Due:
(OA Factor)\*(1+i) = AD Factor
- Change from Due to Ord:
AD Factor/(1+i) = OA Factor
36
**CAPITAL BUDGET STAGES**
- Six stages:
1. Identification
2. Search
3. Info-Aquisition
4. Selection
5. Financing
6. Implementation/Control
37
**SUNK COST**
- Also known as past or unavoidable cost
- These are committed costs that are not avoidable and therefore irrelevant to the decision process
38
**AVOIDABLE COST**
- Costs that will not continue to be incurred if a department or product is terminated
39
**COMMITTED COSTS**
- Costs whihc arise froma company's basic committment to pen its doors and engage in business
- Examples include depreciation, property taxes, management salaries
40
**DISCRETIONARY COSTS**
- Fixed costs whose level is set by current mgmt decisions
- Examples include advertising, research and development
41
**RELEVANT COSTS**
- Future costs that will change as a result of a specified decsion
42
**DIFFERENTIAL (INCREMENTAL) COSTS**
- The difference in cost between two alternatives
43
**OPPORTUNITY COSTS**
- The maximum income or savings (benefits) foregone by rejecting an alternative
44
**OUTLAY (OUT-OF-POCKET) COSTS**
- The cash disbursement associated with a specific project
45
**PAYBACK PERIOD**
- The number of years to recoup the investment in cash
- Payback Period =
_Investment_
Annual Cash Flow
- limitations include not including total project profitability and not taking into account the time value of money
46
**ANNUAL CASH INFLOW**
Annual Cash Inflow (b/f Tax/Dep)
_- Depreciation/Amort_
= NIBT
_- Taxes_
= NIAT
_+ Depreciation/Amort_
= Annual Cash Inflow
47
**ACCOUNTING RATE OF RETURN**
- The percentage of return on investment each year (higher the better)
_Net Income_
Investment
- Limitations include, the results are effected by any GAAP adoption, makes no adjustment for project risk, makes no adjustment for the time value of money
48
**NET PRESENT VALUE FORMULA**
= NPV = PV of future cash flows - Investment
* Negative NPV is a bad investment
* Nuetral NPV is indifferent
* Positive NPV is a good investment
49
**NET PRESENT VALUE INFO**
1. Advantages -
* Easy to understand in $
* Adj for time value of $
* Considers total profitability
* Method of controlling risk -adj interest rates
* Shows change in shareholder weath
2. Disadvantages
* May not be considered simple
* Does not include mgmt flexibility to change invest
50
**EXCESS PRESENT VALUE INDEX**
- Computes the ratio of the present value of the cash inflows to the inital cost of the project
- If the index is equal to or greater than 100%, the projecct will generate a return equal to or greater than the required rate of return
Formula: 1 X
_PV of Future New Cash Inflows_
Initial Investment
51
**INTERNAL RATE OF RETURN**
- Uses present value tables. The interest rate that would make
PV of Investment = PV of the Benefits of Inestment
- The annuity factor that would make these equal is the same number as the payback period
52
**IRR NOTES**
1. Advantages
* Adjust for time value $
* Hurdle rate based on market rate for similiar investments
* Intuitive results
2. Disadvantages
* No unique IRR, depends on CF pattern used
* May not be exact discount rate
* Mutual exclusive limitations
53
**NPV & IRR**
1. If NPV \> 0; IRR \> Discount Rate
2. If NPV = 0; IRR = Discount Rate
3. If NPV \< 0; IRR \< Discount Rate
54
**LEASE VS. BUY**
- Leasing advantages
1. Tax advantages
2. Less inital investment
3. Less formal buying, ease of loan covenants
4. Certain leases do not need to be capitalized, so no recognition of debt
