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
What is the Capital Asset Pricing Model (CAPM)?
An equilibrium model that specifies the relationship between a stock’s value and its market risk as measured by beta.
What is the Security Market Line (SML)?
The portion of the capital asset pricing model (CAPM) that specifies the relationship between market risk and required rate of return
What are the weaknesses of the CAPM?
It is based on a restrictive set of assumptions and does not conform well to the real world conditions.
What is the strength of the CAPM?
It is simple and logical. It focuses on the impact a single aspect has on a portfolio.
How do Productive Opportunities affect the cost of money?
The higher the profitability of the business, the higher the interest rate the barrower can afford to pay lenders for use of their savings
How do Time Preferences affect the cost of money?
There are two time preferences, low and high time preference. The person with a low time preference is willing to loan funds at a relatively low rate because their preference is for future consumption. The person with the high time preference is willing to lend funds out of current income and forgo consumption only if the interest rate is high.
How does Risk affect the cost of money?
The higher the risk the higher the interest rate
How does Inflation affect the cost of money?
The higher the expected rate of inflation, the higher the interest rate demanded by savers
Real Risk Free Rate (RRF)
The rate of interest on a riskless investment in the absence of inflation. This is the rate that investors would demand on a debt security that is totally riskless when there is no inflation
Inflation Premium (IP)
The premiums that debt investors add to the real risk-free (base) interest rate to compensate for inflation
Default Risk Premium (DRP)
The premium that creditors demand for bearing default risk. The greater the default risk, the higher the default risk premium
Liquidity Premium (LP)
The premium that debt investors add to the base interest rate to compensate for lack of liquidity
Price Risk Premium (PRP)
Raise interest rates on long-term bonds relative to those on short-term bonds. This premium, like the others, is difficult to measure, but it seems to vary over time; it rises when interest rates are more volatile and uncertain and falls when they are more stable.
Call Risk Premium (CRP)
- Bonds that are callable are riskier for investors than those that are noncallable because callable bonds have uncertain maturities. Furthermore, bonds typically are called when interest rates fall, so bondholders must reinvest the call proceeds at a lower interest rate.
- To compensate for bearing call risk, investors charge a call risk premium (CRP) on callable bonds. The amount of the premium depends on such factors as the interest rate on the bond, current interest rate levels, and time to first call (the call deferral period).
What is a yield curve?
A plot of the term structure of interest rates (yield to maturity versus term to maturity).
Is the yield curve static, or does it change over time?
The yield curve changes both in position and in shape over time.
What is the difference between a normal yield curve and an inverted yield curve?
Normal Yield Curve: An upward sloping yield curve.
Inverted Yield Curve: A downward sloping yield curve.
What impact does the yield curve have on debt financing decisions?
In general, to reduce risk, managers try to match the maturities of the financing with the maturities of the assets being financed.
Term Loan Definition
A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate. Term loans almost always mature between one and 10 years.
Bond Definition
Long-term debt issued by a business or governmental unit and generally sold to a large number of individual investors
Mortgage Bond Definition
A bond issued by a business that pledges real property (land and buildings) as collateral
Senior Debt; Junior Debt Definition
Senior Debt - Borrowed money that a company must repay first if it goes out of business.
Junior Debt - debt that is either unsecured or has a lower priority than of another debt claim on the same asset or property. It is a debt that is lower in repayment priority than other debts in the event of the issuer’s default. Junior debt is usually an unsecured form of debt, meaning there is no collateral behind the debt.
Debenture Definition
An unsecured bond: better because they don’t have to back it up with assets
Subordinated Debenture Definition
A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings.
Municipal Bond Definition
A tax-exempt bond issued by a governmental entity such as a healthcare financing authority
Indenture Definition
A legal document that spells out the rights and obligations of both bondholders and the issuing corporation. In other words, the loan agreement for a bond
Restrictive Covenant Definition
Any type of agreement that requires the buyer to either take or abstain from a specific action
Trustee Definition
An individual or institution, typically a commercial bank, that represents the interests of bondholders
Call Provision Definition
A provision in a bond indenture (contract) that gives the issuing company the right to redeem (call) the bonds prior to maturity
Par Value + Interest up to that point + Premium
What do Bond Ratings measure?
The probability of default
Why are bond ratings important to businesses that issue bonds?
They impact the cost of debt capital
What is Credit Enhancement?
Bond Insurance that guarantees the payment of interest and repayment of principal on a bond even if the issuing company defaults
What three factors primarily influence the general level of interest rates?
- Federal Reserve policy
- Federal budgetary policy
- Overall level of economic activity
What is Interest Rate Risk?
The risk to current debt holders that stems from interest rate changes
What is Price Risk?
The risk of a decline in the value of a security or a portfolio.
What is Reinvestment Rate Risk?
Two factors that have a bearing on the degree of reinvestment risk are:
- Maturity of the bond - The longer the maturity of the bond, the higher the likelihood that interest rates will be lower than they were at the time of the bond purchase.
- Interest rate on the bond - The higher the interest rate, the bigger the coupon payments that have to be reinvested, and consequently the reinvestment risk.
What are the three primary bond rating agencies?
Fitch Ratings, Moody’s Investors Service (Moody’s), and Standard & Poor’s (S&P)
