Exam 3 Flashcards
What is an opportunity cost rate?
The opportunity cost (discount) rate applied to investment cash flows is the rate that could be earned on alternative investments of similar risk.
How is the Opportunity Cost Rate used in time value analysis? And is this a single number that can be used in any situation?
The cash flows expected to be earned from any investment must be discounted at a rate that reflects the return that could be earned on forgone investment opportunities.
No the rate varies depending upon the situation and the opportunity costs at stake.
What is the difference between a lump sum, an annuity, and an unequal cash flow stream?
- Lump sums are single values
- Annuity is a series of equal payments at fixed intervals for a specified number of periods
- Unequal cash flow is when an analysis involves more than one lump sum that does not meet the definition of an annuity
Which growth rate has more meaning—the total rate over ten years or the annualized rate?
The annual rate has more meaning because it is the average growth over the 10 years.
Would you rather have a savings account that pays 5 percent compounded semiannually or one that pays 5 percent compounded daily?
One that pays 5 percent compounded daily. The more times that it compounds; would be more times that your money is able to earn interest
What is the future value of a perpetuity?
Since perpetuity means there is no end, there is no specific formula. You find the future value over one period and then treat it as an ordinary annuity.
When a loan is amortized, what happens over time to the size of the total payment, interest payment, and principal payment?
- Size of total payment: Stay the same
- Size of interest payment: Decrease
- Size of principal payment: Increase
Stated Rate
The annual rate that is normally quoted in financial contracts
Periodic Rate
Equals the stated rate divided by the number of compounding periods per year
Effective Annual Rate
Rate that produces the same results under annual compounding as obtained with frequent compounding
Explain the concept of return on investment (ROI) and the two different approaches to measuring ROI.
Return on investment is a concept that helps you determine as a manager just how much you are making back on purchases that have been made. This will give an idea if the purchase is worth it or paying itself off.
- The dollar return
- Percentage return
Stock A has an expected rate of return of 8 percent, a standard deviation of 20 percent, and a market beta of 0.5. Stock B has an expected rate of return of 12 percent, a standard deviation of 15 percent, and a market beta of 1.5. Which investment is riskier?
- Stock A is riskier than stock B if you use standard deviation to determine the risk. Stock A has a standard deviation of 20%, while stock B has a standard deviation of 15%.
- Stock B is riskier than stock A if you use market beta to determine the risk. Stock B has a Market beta of 1.5 and Stock A has a market beta of 0.5
What is risk aversion?
The tendency of individuals and businesses to dislike risk. The implication of risk aversion is that riskier investments must offer higher expected rates of return to be acceptable.
Explain why holding investments in portfolios has such a profound impact on the concept of financial risk.
A stock held alone (in isolation) is riskier than the same stock held as part of an investors’ large portfolio (collection) of stocks. This is because you are diversifying your holdings.
Assume that two investments are combined in a portfolio:
In words, what is the expected rate of return on the portfolio?
The weighted average of the return distribution, where the weights are the probabilities of occurrence. (Probability of Return 1 × Return 1 + Probability of Return 2 × Return 2… = EROR)
What condition must be present for the portfolio to have lower risk than the weighted average of the two investments?
Correlation (r) is less than positive 1
Is it possible for the portfolio to be riskless? If so, what condition is necessary to create such a portfolio?
Yes, Correlation (r) = -1
Portfolio Risk
The riskiness of an individual investment when it is held as part of a diversified portfolio as opposed to held in isolation
Diversifiable Risk
The portion of the risk of an investment that can be eliminated by holding the investment as part of a diversified portfolio.
Corporate Risk
The portion of the riskiness of a business project that cannot be diversified away by holding the project as part of the business’s portfolio of projects
Market risk
The portion of riskiness of a business project that cannot be diversified away by holding the stock of the company as a diversified portfolio
How is Corporate Risk Measured?
Corporate beta, or corporate b, which is the slope of the regression line that results when the project’s returns are plotted on the Y axis and the overall returns on the firm are plotted on the X axis. A corporate beta of 1.0 indicates that the project’s returns have the same volatility as the business’s returns.
How is Market Risk Measured?
A project’s market beta, or market b, measures the volatility of the project’s returns relative to the returns on a well-diversified portfolio of stocks, which represents a large portfolio of individual projects. A market beta of 1.0 indicates that the project’s returns have the same volatility as the market—such a project has the same market risk as the market portfolio.
Under what circumstances is each type of risk—stand alone, corporate, and market—most relevant?
- Stand Alone is most relevant to investments held in isolation
- Corporate Risk is most relevant when looking at a project in a business
- Market Risk is most relevant when measuring the volatility of a project
