Financial Risk Management and Capital Budgeting Flashcards
Avoidable costs
costs that will not continue to be incurred if a particular course of action is taken
Cash flow hedge
a hedge of the variability in the cash flows of a recognized asset or liability or of a forecasted transaction that is attributable to a particular risk
Committed costs
costs related to the company’s basic commitment to open its doors (ie depreciation, property taxes, management salaries, etc)
Credit (default) risk
the risk that a firm will default on a payment of interest or principal of a debt
Currency swaps
forward-based contracts in which two parties agree to exchange an obligation to pay cash flows in one currency for an obligation to pay in another currency
Differential (incremental) costs
the difference in cost between two alternative courses of action
Discretionary costs
fixed costs whose level is set by current management decisions (eg, advertising research and development)
Fair value hedge
a hedge of the changes in fair value of a recognized asset or liability, or of an unrecognized firm commitment
Forwards
negotiated contracts to purchase and sell a specific quantity of a financial instrument, foreign currency or commodity at a price specified at the origination of the contract with delivery and payment at a specified future date.
Futures
Forward-based standardized contracts to take delivery of a specified financial instrument, foreign currency or commodity at a specified future date or during a specified period generally at the then market price.
Interest rate risk
the risk that the value of a debt instrument will decline due to an increase in prevailing interest rates
Interest rate swaps
forward-based contracts in which two parties agree to swap streams of payments over a specified period of time. These contracts are often used to trade variable-rate instruments for fixed-rate instruments
Internal rate of return method
uses the rate of return that equates investment with future cash flows to evaluate investment alternatives
- TVMF = PV (investment today)/Cash flows
- discount rate is the end result of the calculation
- also called the time-adjusted rate of return
Market risk
the risk that the value of a debt instrument will decline due to a decline in the aggregate value of all assets in the economy
net present value method
uses the present value of future cash flows to evaluate investment alternatives
- NPV = (PV future cash flows) - Investments
- assumes the projects cash flows are reinvested at the NPV discount rate (usually the cost of capital)
- discount rate also called the hurdle rate
Opportunity cost
the maximum income or savings (benefit) foregone by rejecting an alternative
Options
an instrument that allows, but does not require, the holder to buy (call) or sell (put) a specific or standard commodity or financial instrument, at a specified price during a specified period of time or at a specified date
Outlay cost
the case disbursement associated with a specific project
Payback method
evaluates investment alternatives based on the length of time until the investment is recaptured
- considers tax savings from depreciation
- does not consider TVMF
Relevant costs
future costs that will change as a result of a specific decision
Sensitivity analysis
exploring the importance of various assumptions to forecasted results
Sunk (unavoidable) costs
committed costs that are not avoidable and are therefore irrelevant to future decisions
Swaption
an option of a sap that provides the holder with the right to enter into a swap at a specified future date with specified terms
Systematic risk
the risk related to market factors which cannot be diversified away
Unsystematic risk
the risk that exists for one particular investment or a group of like investments. This risk can be diversified away
Accounting Rate of Return
= annual net income / average (or initial) investment
Profitability Index
net present value of future cash flows / amount of initial investment
- if greater than 1, NPV is positive
Cost of capital
the rate management must pay to obtain funds
NPV vs IRR
NPV > 0 then IRR > Discount Rate
NPV = 0 then IRR = Discount Rate
NPV < 0 then IRR < Discount Rate
Depreciation tax shield
benefit of depreciation in cash flow analysis = resulting tax savings
Coefficient of Variation
= standard deviation / expected return
Diversified company / Portfolio risk
= weighted average of project risk
