Cost concepts Flashcards
Opportunity cost
Discounted dollar value of benefits lost from an opportunity not taken as a result of choosing another opportunity
What determines a firm’s cost of capital?
The rate of return investors can earn in the market on securities with comparable risk
What are the major elements of a firm’s capital (or capital structure)?
Long term debt
preferred stock
common stock
Unexpired cost
Asset. It has future value to the entity.
Ex: the cost of a 3 year insurance policy would be an asset during the period covered.
Expired cost
Expense. The benefit to an entity from the G/S that has been used up and is of no future value to the entity. It is either an expense (cost of wages) or a loss (cost of goods destroyed by a fire)
What elements are used in the capital asset pricing model formula?
Risk free rate of return. Beta - a measure of volatility for the asset being valued. The expected rate of return for the entire class of the asset being valued.
What is the required rate formula (CAPM formula)
risk free rate + beta(expected rate - risk free rate) = required rate.
What does beta graphed show the relationship of?
the relationship between the return of an individual asset and the return of the entire class of that asset.
Beta
a measure of the systematic risk associated with an investment as reflected by its volatility as compared with the volatility of the entire class of the investment
CAPM (capital asset pricing model)
economic model that determines the relationship between risk and expected return and uses that measure in assigning value to securities, portfolios, capital projects and other assets.
The risk free rate of return is a measure of…
the time value of money
Black Scholes model
Mathematical formula for valuing stock options, which are derivative iinstruments.
european call options
options for stocks that pay no dividends
options for stocks whose price increases in small increments
discounting the exercise price using the risk free rate which is assumed to remain constant.
what are advantages to Black Scholes
Assigns probabaility factor to the likelihood that the price of the stock will pay off within the time to expiration.
Assigns probability factor to the likelihood that the option will be exercised.
Discounts the exercise price to present value.
How do you capitalize earnings to determine the value of a business?
annual earnings/ required rate of return.
What are the approaches to assigning a value to an entire business?
Market
Income
Asset
