Corporate Finance Flashcards
A measure that describes the risk of an investment project relative to other investments.
Beta coefficient
The beta coefficient of an individual stock is the correlation between the
volatility (price variation) of the stock market and that of the price of the individual stock.
For example, if an individual stock goes up 15% and the market only 10%, the stock’s
beta is 1.5.
For this reason, beta is a measure that describes the risk (volatility) of an
investment project relative to other investments in general (the market).
The required rate of return on equity capital in the capital asset pricing model OR expected market rate of return
=RF + B (RM - RF)
The difference between the required rate of return on a given risky investment and that
on a riskless investment is the
Risk premium for that security
If an asset is plotted below the SML, it implies that:
The asset is overvalued.
Overvalued stocks will lie below the SML because their expected returns are lower than the required return.
CAPM
CAPM describes the relationship between risk and expected return of investments.
It is used to determine how much return investors require for an investment given its systematic risk, with the systematic risk being measured by a stock’s beta.
It can also be used to estimate the cost of a company’s equity capital.
According to the model, the expected return is based on the investment’s beta, the risk-free rate of return, and the return the market portfolio.
term structure of interest rates
relationship between the term to maturity and the yield to maturity of the debt instrument
greatest impact on a bond’s interest rate sensitivity
The time until the bond matures.
A bond’s interest rate sensitivity concerns how much the market value of the bond will change when market interest rates change. The most significant factor affecting a bond’s interest rate sensitivity is the time until the bond matures.
As the time to maturity increases, interest rate sensitivity also increases. This is because there is more time for changes in market interest rates to impact market value as the time to maturity increases.
P/E ratio (price/earnings per share)
can be used to evaluate the riskiness and growth potential of a stock. The higher the ratio the higher the growth potential.
Specifically, it measures how much an investor is willing to pay for $1 in earnings. The idea is that an investor would be willing to pay more for $1 in earnings from a company that is expected to grow more than from a company that is expected to grow less. It can also measure risk as higher growth is often related to greater growth.
general dividend valuation model
assumes that the value of a firm’s common stock is the present value of the dividends expected by the market.
