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Finance Exam 3
the final exam
| Term | Definition |
|---|---|
| Risk Premium | difference between return on risky investment and the return on a risk free investment. The reward for bearing risk and larger premium on riskier investments. |
| Expected Return | the return on a risky asset expected in the future, the actual return could be higher or lower |
| Calculating Variance (Sigma Squared) | 1.) Find Expected Return 2.) Find the difference between the expected return of the individual stock and the portfolio then square it 3.) Multiply each by their probability then add it all up |
| Standard Deviation of Return on Securities (Sigma) | Find the square root of the variance |
| portfolio | group of assets such as stocks and bonds held by an investor |
| portfolio weight | the percentage of a portfolio's total value that is invested in a particular asset (weight sums to 1 or 100) |
| Portfolio Expected Return | weighted average of expected returns for all assets in a portfolio, create weight based on amount invested in each dividend by total |
| variance of portfolio | not a combination of variances of assets |
| 2 Parts of Returns on Traded Stocks | Expected (predicted by market) and Unexpected Return (from unexpected information revealed) |
| Total Return vs. Expected Return | actual return may differ from the expected return in a given year but in long run the average return will equal the average expected return |
| Announcements | expected part + surprise, expected part is used by the market to form expectations and the surprise influences the unexpected return |
| Innovation/ surprise | difference between actual result and forcast |
| Systematic Risk | risk that influences a large number of assets, also called market risk ( Ex. GDP, Interest Rates, & Inflation) |
| Unsystematic Risk | risk that affects a very small number of assets, unique asset or very specific risk ( Ex. Pharma Research, Oil Strike, or Tech Advancements) |
| Diversification | process of spreading an investment across assets and forming a portfolio |
| Principle of Diversification | highly diversified portfolios have little to no unsystematic risk. |
| Nondiversifiable Risk | there is a minimum amount of risk that cannot be eliminated by diversification |
| Interchangeable Risk Terms | Diversifiable, Unsystematic, Unique, and Asset-Specific |
| Systematic risk principle | the expected return of a riskey asset depends only on that asset's systematic risk, unsystematic risk can be eliminated at virtually no cost by diversifying so there is no reward for bearing it |
| Beta coefficient | the amount of systematic risk present in a particularly risky asset relative to the risk in an average asset ( Average asset has beta of 1) |
| Relationship between beta and expected return | assets with larger betas will have greater systematic risks which will lead to greater expected returns |
| portfolio beta | calculated by multiplying each assets beta bu its portfolio weight then adding all together |
| Market risk premium | difference between the market expected return and the risk free rate ( slope of SML) |
| Stock risk premium | risk premium of a stock is equal to the market risk premium multiplied by the stocks beta |
| Security Market Line (SML) | reward to risk ration must be the same for all assets on the market, shows relationship between systematic risk and expected returns in financial markets |
| A positive SML | shows a expected return and beta |
| Slope of SML | represents market risk premium, difference between the expected return on market portfolio and the risk free rate |
| Capital Asset Pricing Model (CAPM) | equation of SML showing relationship between expected return and beta |
| CAPM Equation | E(r) = Rrf + B(Rm-Rrf) |
| CAPM shows that expected return depends on 3 things | 1.) Pure Time Value of Money 2.) The Reward for Bearing Systematic Risk 3.) The amount of systematic risk |
| CAPM for Portfolios | works the same as it does for individual assets |
| Alpha | the excess returns an asset earns based on the level of risk taken, distance between the actual return and the SML |
| Positive Alpha | Asset of portfolio has earned a return greater than what it should have based on its beta |
| Negative Alpha | asset of portfolio has earned a return less than what it should have based on its beta |
| Determining Total Risk | measured by variance of standard deviation of its return |
| Reward to Risk Ratio | ratio of risk premium to its beta, ratio should be same for every asset in a well functioning market |
| Net Present Value | the difference between an investment's market value and its cost, how much value is created or added today by taking an investment (an estimate), capital budgeting looks for investments with positive NPV |
| Net Present Value Rule | an investment should be accepted if the net present value is positive and rejected if it is negative |
| Discounted Cash Flow Valuation | process of valuing an investment by discounting its future cash flows |
| Payback period | amount of time it takes to recover our initial investment |
| Payback period rule | an investment is acceptable if its calculated payback period is less than some pre-specified number of years, could include a fractional year |
| Issues with payback period rule | ignores the time value of money, does not consider risk differences between projects, no objectivty for choosing cutoff period, ignores cash flow beyond cutoff, biases towards shorter term investments |
| Why payback period is used | used by large and sophisticated companies when making minor decisions because of its simplicity, bias towards liquidity, adjusts for riskiness of later cash flows since they are more uncertain |
| Discounted payback period | length of time required for an investments discounted cash flows to equal its initial costs |
| discounted payback rule | an investment is acceptable if its discounted payback is less than some pre-specified number of years (must have positive NPV assuming all cash flows past initial are positive) |
| Issued with discounted payback | not simple to calculate, cutoff is chosen objectively, cashflows beyond cutoff are ignored, could falsely reject positive NPV |
| Internal Rate of Return (IRR) | the discount rate that makes the NPV of an investment zero, called the discounted cash flow or DCF return |
| IRR Rule | an investment should be accepted if the IRR exceeds the required return |
| IRR and NPV decision rules | always lead to identical decisions as long as project cash flows are conventional and the project is independent |
| Issues with IRR | if cashflows are nonconventional the IRR is not reliable, if projects are not mutually exclusive NPV and IRR can conflict, project size is not factored with IRR |
| crossover rate | the discount rate that makes the NPVs of 2 projects equal, found by taking difference in cash flows and calculating the IRR using the difference |
| Finding crossover rate | find the difference between each of the cash flows and set them up as Cf0, Co1, etc, Compute IRR button, can subtract in any order but must stay consistant |
| Mutually exclusive | only one investment can be chosen, even if both meet criteria |
| Modified Internal Rate of Return (MIRR) | modify cash flows then calculate the IRR, depends on the external discount rate so it will not produce a true "internal" rate of return, does not suffer from multiple rates of return |
| Calculating MIRR | Find NPV for negative cash flows, find NPV for positive cash flows and then solve for the FV of those cash flows,, use TVM with PV = NPV of negative, N= project life, FV= positive cash flows, PMT= 0, solve for I/Y |
| Combination Approach | modification for MIRR, negative cash flows are discounted back to the present, positive cash flows are compounded to the end of the project |
| Relevant Cash Flows | a change in the firms overall future cash flow that comes about as a direct consequence of the decision to accept the project |
| Incremental Cash Flows | the difference between a firm's future cash flows with a project and the cash flows without the project, any and all changes that are a direct consequence of taking that project |
| Irrelevant Cash Flows | any cash flow that exists regardless of whether or not a project is undertaken |
| Stand Alone Principle | the assumption that the evalucation of the project may be based on incremental cash flows, the project is evaluated on its own merits in isolation from other activities, and its evaluated on incremental cash flows not total cash flows |
| Sunk Cost | a cost that has already been incurred and cannot be removed, therefore should not be considered an investment decision |
| Opportunity Cost | the most valuable alternative that is given up if a particular investment is taken, not an out of pocket cost, but a benefit forgone, "next best thing" |
| side effects | project may have side/spill over effects, good or bad |
| Erosion | the cash flows of a new project that come at the expense of a firms existing projects, negative impact on the existing cash flows from the introduction of a new project |
| Net working capital | covers the initial investment, expenses, supplied by the firm at the beginning of the project and recovered at the end, if we have a NWC investment it has to be recovered |
| Financing Costs | interest paid and other financing costs, is NOT included when analyzing investments |
| Pro Forma Financial Statements | financial statements projecting future years operations, interest expense will not be deducted when calculating OCF |
| Fixed Cost | cash outflow that will occur regardless of the level of sales |
| Project cash flow components | project operating cash flow, project change in net working capital, project capital spending |
| Project cash flow equation | Project Cash Flow = Project Operating Cash Flow - Project Change in NWC - Project Capital spendign |
| Operating cash flow equation | earnings before interest and taxes (EBIT) + depreciation - taxes |
| Depreciation | non-cash deduction, only affects cash flows because of its tax influence |
| Accelerated Cost Recovery System (ACRS) | depreciation method under US tax law allowing for accelerated write-off property under various classifications |
| Straight Line Depreciation | asset will be fully depreciated at the end of its lifespan, depreciation expense is the same every year, book value at the end of project life is zero |
| Bonus Depreciation | all bonus depreciation is 100% in the first year, increases the NPV of projects because the depreciation tax shield is a cash inflow |
| Book Value vs Market Value | the difference is the excess depreciation that will be "recaptured" when the asset is sold, if book value is greater than market value the difference is looked at as a loss for tax purposes |
| Buttom Up OFC | OFC = Net Income + Depreciation |
| Top Down OFC | OFC = Sales - costs - taxes |
| Tax Shield Approach | OFC = (Sales - Cost) x (1-T) + (Depreciation x T) |
| Depreciation Tax Shield | the tax saving that results from the depreciation deduction, calculated as the depreciation multiplied by corporate tax rate |
| Equivalent Annual Cost | present value of a projects cost calculated on an annual basis, only can be used when the options have different economic lives and they have indefinite need (will be replaced at the end), choose whichever project has the smallest EAC |
| After Tax Salvage Value Equation | Salvage Value - (Salvage Value - Book Value)x(Tax Rate) |
| Calculating Equivalent Annual Cost | Use cash flow keys to find NPV of project, then TVM keys with NPV as PV, Fv as 0, N is life of project , I/Y as a given rate, solve for PMT |
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user-2007035