chapter 3 Flashcards
competitive market
a market in which a good can be bought and sold at the same price. that price determines the cash value of the good.
Valuation Principle
states that the value of an asset to the firm or its investors is determined by its competitive market price. the benefits and costs of a decision should be evaluated using market prices and when the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm.
time value of money
the difference in value between money today and money in the future.
risk-free interest rate (rf)
the interest rate at which money can be borrowed or lent without risk over that period.
interest rate factor
(1 + rf) is the interest rate factor for risk-free cash flows. it defines the exchange rate across time and has units of ‘$ in one year/$today’.
present value (PV)
when we express the value in terms of dollars today.
future value (FV)
when we express the value in terms of dollars in the future.
discount factor/rate
the discount at which we can purchase money in the future. it represent the price today of $1 in one year.
net present value (NPV)
the difference between the present value of the benefits and the present value of the costs. it expresses the value of an investment decision as an amount of cash received today.
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.
arbitrage
the practice of buying and selling equivalent goods in different markets to take advantage of a price difference.
arbitrage opportunity
any situation in which it is possible to make a profit without taking any risk or making any investment. once spotted, they will quickly disappear. thus, normally no arbitrage opportunities exist.
normal market
a competitive market in which there are no arbitrage opportunities.
Law of One Price
if equivalent investment opportunities trade simultaneousely in different competitive markets, they must trade for the same price in all markets.
financial 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
the person who intends to sell a security first borrows it from someone who already owns it. later, that person must either return the security by buying it back or pay the owner the cash flows he or she would have received.
no-arbitrage price
the price where no arbitrage opportunity exists.
the bond’s return
the percentage gain that you earn from investing in the bond, which is equal to the risk-free interest rate.
separation principle
security transactions in a normal market neither create nor destroy value on their own. therefore, we can evaluate the NPV of an investment decision separately from the decision the firm makes regarding how to finance the investment or any other security transactions the firm is considering.
portfolio
a collection of securities.
value additivity
the price of an asset must equal the sum of prices of its component assets. so, Price (A+B) = Price A + Price B. this is true if the law of one price holds.
risk aversion
the notion that investors prefer to have a safe income rather than a risky one of the same average amount.
risk premium
the risk premium of a security represents the additional return that investors expect to earn to compensate them for the security’s risk.
decision payoff
the decision payoff from an action that consumer feels responsible for is a weighted average of his private payoff and a fraction of the social surplus corresponding to the action, and the fractional weight on the social surplus term equals consumer’s shareholding.
final payoffs
once the consumer has made his decision - taking externalities into account - he is no longer plagued by this decision. he neither suffers from externalities resulting from it nor receives a warm glow from avoiding them.
amoral drift
the market for corporate control will push a board who wants to choose clean into a choice of dirty. if a shareholder thinks the bid will fail, it is better for them to tender since he will receive p and can always buy back the shares. so, tendering is a dominant strategy even for a prosocial shareholder and the bid succeeds.
“Friedman” charter
specifies profit maximisation as the goal.
separation principle
in a normal market we can separate the firm’s investment decision from its financing decision because security transactions neither create nor destroy value on their own in a normal market (NPV of buying or selling securities is 0).
compounding
calculating the future value of a cash flow. the idea is that we earn interest on the principal and on previous interest payments.
discounting
moving a cash flow backward in time.
