Finance Flashcards
What is the time value of money
The idea that money is more valuable today than in the future, since it can be invested to earn interest r
Give the equation for rates of return
What is the compound interest calculation
CT = C0(1 + r)T
Whats the holding period return
the overall return for the full period
r = (1 + rt)1/t - 1 where rt is the interest rate per period
What’s present value
the value of all future cash flows
What is the discount factor
1 / (1 + r)
Whats a zero coupon bond
A bond that costs CF0 today and promises to make CFT = (1+r)CF0 in the future
What’s Net Present Value
the present value of all its future cash flows minus the present value of it’s costs
What is the Capital budgeting rule for Present value?
Take all with NPV > 0
What’s a perpetuity?
A bond that pays C pounds, per period, forever.
What’s the equation for a growing perpetuity
State the three equations associated with the Gordon Growth model
What’s an annuity
an instrument that pays CF for T years
Whats the equation for a growing annuity
What’s the internal rate of return
the value of the discount rate r which sets the NPV = 0
does the IRR reflect cost of capital?
NO
What’s the capital budgeting rule for IRR
Accept the project if it’s IRR is higher than a ‘hurdle rate’
Give 2 advantages and 2 disadvantages for using IRR
- allows for a margin of error
- doesnt include cost of capital
- some projects have no IRR, others have multiple
- can’t handle different interest rates for different periods
Give the steps for incremental cash flow analysis
i) order alternatives in increasing order of the initial investment
ii) if the smallest investment has IRR > hurdle rate we consider the incremental cash flow
iii) if the IRRincremental > hurdle then accept the more expensive investment
Whats Profitability index and give the capital budgeting rule
The PV of the future cash flows, divided by the cost.
Invest if PI > 1, reject if PI < 1
Whats the payback rule
Choose the project with the shortest payback time, or projects that payback sooner than some cut off
What’s the Yield to maturity
the discount rate that sets the NPV of the bond equal to 0
P0 = FV / (1 + YTM)n
Whats expected value and variance?
what utility functions fit
i) risk averse
ii) risk neutral
iii) risk seeking
i) U(w) = w1/2
ii) U(w) = w
iii) U(w) = w2
What is expected interest rates and promised interest rates equal to
Expected interest rates = Time premium
Promised interest rates = Time premium + default premium
What are equity holders repaid?
whatever profits remain after bond holders are paid off
Whats covariance?
Whats correlation?
What is the expected return on a market portfolio consisting of X and Y
What’s the variance of the market portfolio
What are diversification benefits
come from mixing together assets with less than perfect co-movement, makes the portfolio less volatile
What shocks are eliminated by diversification
firm specific shocks
What is the market portfolio
Tangency portfolio, the portfolio that provides the highest return per unit of risk
Whats the association between project P and the market portfolio M
What is CAPM?
Capital Asset Pricing Model
State the CAPM
How do we calculate NPV when using CAPM
numerator uses expected cash flows, cost of capital is expected return, derived from CAPM
For risk averse investors, what are promised returns and expected returns
promised returns = time premium + default premium + risk premium
expected return = time premium + expected risk premium
When a firm has equity, what is the betaproject
in a stock market, what do we buy and sell at
buy at ask price, sell at bid price
Whats the average tax rate
total tax paid / total taxable income
what is rafter tax
(1 - marginal tax rate) rbefore tax
What is the nominal and real cash flow
nominal cash flow is simply the number of pounds you pay
real cash flow is adjusted for inflation
whats the relationship between real r and nominal R interest rates
1 + r = 1 + R / 1 + inflation
What does the Modiglani Miller irrelevance theorem state?
in perfect markets the firm value is equal to PV, regardledd of how its projects are financed
Does MM hold in imperfect markets?
No
Give the equation for APV, adjusted present value
What is the debt to capital ratio
Debt / APV
What is pricecum-dividend
priceex
The price before the expiration date, Pcum = current dividend + PV(future dividend)
Pex = PV(future dividend)
In imperfect markets, do investors prefer repurchases or dividends?
repurchases, since dividends typically are charged at a higher tax rate
What is a call option?
a contract that gives its owner the right to buy the asset at some future date at some specificed price
What is a put option?
a contract that gives its owner the right the sell the asset at some future date at some specified price
whats the strike price?
the pre-specified price at which the owner can buy or sell the asset
When should we buy
When S(stock price) > K(strike price)
Pricecall = max(S-K, 0)
When should we sell?
When S < K
Pput = max ( K-S , 0)
What does the law of one price state?
S + P = PV(K) + C
known as put-call parity
