Chapter 3: Financial Decision Making and the Law of One Price Flashcards
Risk free rate
The interest rate at which money can be borrowed or lent without risk over that period
Risk Aversion
Investors preferring to have guaranteed income rather than uncertain income equal to the same expected amount. Therefore, if the cash flows of an investment are uncertain, investors will demand a higher expected return to be compensated for that risk.
Risk premium
The additional return that investors expect to earn above the risk-free rate to compensate them for the risk of the investment
Volatility
Measure of the risk and uncertainty, this increases causing the demand for risk premium to increase from investors
Opportunity Cost of capital
The best available rate offered by the market for a security of comparable risk and term to the investment opportunity being considered.
Arbitrage
An opportunity to make a risk-free profit by simultaneously buying and selling equivalent goods in different markets to take advantage of a price difference.
Law of One Price
If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in all possible markets.
Replicating Portfolio
Reproduces the cash flows of the security that we are trying to price based on securities whose prices we know
Fisher Separation Theorem
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 financial transactions being considered by the firm.
Net Present Value Rule
To compare the costs and benefits of various investments we look at estimates of their cash flows and compute their Net Present Values. NPV > 0 - we invest, NPV < 0 - reject the project
IRR Rules
The IRR Decision Rule states:
- Accept those projects when IRR exceeds the opportunity cost of capital
- Reject those projects when the IRR is less than the opportunity cost of capital
IRR Limitations
- Sign change in the cash flows over time
- Multiple IRR’s
- Investor versus borrower - Size of opportunity - Too little value creation for the effort
- Riskiness may not be taken into account
4.Timing of Cash Flows not taken into account
Payback Period
The number of years it takes to earn back your investment amount
Payback Rule
The Payback Decision Rule states:
- Accept those projects when the payback period is less than a certain amount of years
- Reject those projects when payback period exceeds the desired amount of years
Payback Limitations
- Doesn’t help to identify opportunities that provide an adequate return. No Present Value or NPV calculations are used
- Ignores cash flows past the payback period
