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BEC 43

Financial Risk Management and Capital Budgeting

QuestionAnswer
Unsystematic risk the risk that exists for one particular investment or a group of investments; a balanced portfolio can eliminate this risk
Systematic risk risk that relates to market factors that cannot be diversified away
Beta measures how investment's value moves with chg in the value of the portfolio; if B > 0, risk is correlated with portfolio ==> increases portfolio risk (higher= more risk); if B <0 risk is not correlated ==> investment decreases the risk of the portfolio
Credit or default risk risk that the firm will default on payment of interest or principal of the loan or bond (unsystematic risk)
interest rate risk risk that the value of the loan or bond will decline due to increase in interest rates
market risk 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
stated interest rate the contractual rate charged by a lender
effective interest rate the true annual return to the lender
EAR (effective annual interest rate) (1+stated rate/compounding frequency)4-1
Normal yield curve upward sloping curve I which short term rates are less than intermediate term rates which are less than long term rates.
Maturity risk premiums long term rates are usually higher due to premiums to account for interest rate risk
Liquidity preference (premium) theory LT rates should be higher than ST rates because investors have to be offered a premium to hold less liquid and more price sensitive securities
Market segmentation theory treasury securities are divided into market segments by various financial institutions. Commercial banks- ST; Savings and loans =intermediate term; life insurance companies = LT; demand is dependent upon demands of segmented groups of investors
Expectations theory LT rates reflect the average of ST expected rates over time periods that the LT security will be outstanding
Options buy (call) or sell (put) an instrument or commodity at a specified price during a specified period or date
Forwards negotiated contracts to buy or sell a specific quantity of an instrument, currency, or commodity at a price specified at the origination of the contract, with delivery and payment at a future date
Futures forward based contract to take delivery of a financial instrument, currency, or commodity at a specified date in the future or during a specified periods at the then market price
Currency swaps agreement to exchange an obligation to pay cash flows in one currency for an obligation to pay cash flows in another currency
Interest rate swaps agreement to swap streams of payments over a specified period of time
Swaption an option of a swap that provides the right to enter into a swap at a specified date in the future with specified terms or to extend or terminate the life of an existing swap
Derivative risks 1) credit risk- default by the counterparty 2) market risk 3) basic risk – ineffective hedge 4) legal risk
Fair value hedge to hedge changes in fair value of an asset or liability or unrecognized firm commitment; change in fair value recognized in current earnings
Cash flow hedge to hedge the variability of cash flows of an asset or liability or forecasted transaction; change in fair value recognized as OCI (effective portion) and in current earnings (ineffective portion)
Foreign currency hedge to hedge an asset or liability in another currency, cash flow in another currency, investment in a foreign operation
Black- Scholes option pricing model a mathematical model for estimating the price of stock options using 5 variables: time to expiration, exercise or strike price, risk free rate of return, price of underlying stock, volatility of the price of the underlying stock
Zero coupon method used to determine the fair value of interest rate swaps; a present value model in which the net settlements from the swap are estimated and discounted back to their current value
Capital budgeting stages 1) identification stage 2) search stage 3) information- acquisition stage 4) selection stage 5) financing stage 6) implementation and control stage
Capital budgeting models 1) payback and discounted payback 2) accounting rate of return 3) net present value 4) excess present value index 5) internal (time adjusted) rate of return
Payback and discounted payback evaluates investment on length of time until recapture of the investment; ignores total project profitability, does not take into account time value of money Discounted payback- discounts the cash flows before determining payback
Accounting rate of return computes an approximate rate of return which ignores the TVM, risk and is affected by depreciation method since it uses NI; simple and intuitive ARR= annual net income/average ( or initial) investment
Net Present Value (NPV) present value of the future cash flows – required investment; use minimum rate or return mgmt. is willing to accept and not less than the cost of capital for the discount rate
Excess present value (profitability) index used when there are limited funds to available for capital investment Excess present value index = (PV of future net cash inflows/initial investment) x 100
Internal rate of return determines discount rate at which the PV of the future cash flows will exactly equal the investment outlay. This rate is compared with the minimum desired rate of return to determine if the investment should be made.
Considering risk in capital budgeting 1) probability analysis-derive standard deviation based on normal curve2)risk adjusted discount rate 3) time adjusted discount rates 4)sensitivity analysis 5) scenario analysis 6)simulation models 7) decision trees 8) real options 9) lease v. buy
Coefficient of variation standard deviation/expected value of the investment
Created by: tsp7c