Financial Risk Management and Capital Budgeting Flashcards
The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are compensated with a higher premium.
Equity risk premium
Investors that prefer investments with higher returns whether or not they have risk; risk is a nonfactor
Risk-neutral investors
Investorst hat prefer totake risks and would invest in a higher-risk investment despite the fact that a lower-risk investment might have the same return
Risk-seeking investors
The sum of the historical returns for anumber of periods and dividing by the number of periods *recommended for assets with shorter holding periods
Arithmetic average return
A computation that depicts the compound annual return earned by an investor who bought hte asset and held it for hte number of historical periods examined *recommended for assets with longer holding periods
Geometric average return
A financial measure that captures the degree to which the asset returns move together over time in a portfolio
covariance
the risk that exist for one particular investment or a group of like investments –can be eliminted by diversification
unsystematic risk
Rsik that relates to market factors that cannot be diversified away (ex. fluctuations in GDP, inflation, interest rates, etc.)
Systematic risk
A standardized measure that has been developed to estimate an investemnt’s systematic risk
Beta
Describe an investor’s trade-off between risk and return
Risk preference function
An investment portfolio that falls on the line described by an investor’s risk preference function
Efficient portfolio
The risk that the firm will default on payment of interest or principal of hte loan or bond; can be divided into a firm’s creditworthiness and sector risk
Credit or default risk
The risk related to economic conditions in the firm’s economic sector; an unsystematic risk
Sector risk
The riskthat the value of hte loan or bond will decline due to an increase in interest rates; a systematic risk
Interest rate risk
The risk that hte value of hte loan or bond iwll decline due to a decline in hte aggregate value of all the assets in the economy; a systematic risk
Market risk
The contractual rate charged by the lendor
stated interest rate
The interest rate that reflects the true annual return to the lender
effective annual interest rate
An upward sloping interest rate curve in which short-term rates are less than intermediate-term rates which are less than long-term rates
Normal yield curve
A downward-sloping curve in which short-term rates are greater than intermediate-term rates twhich are greater than long-term rates
Inverted (abnormal) yield curve
A yield curve in which short-term, intermediate, and long-term rates are all about the same
Flat yield curve
A yield curve in wich intermediate-term rates are higher than both short-term and long-term rates
Humped yield curve
A theory that stattes that long term interest rates should be higher than short-term rates because investors have to be offered a premium to entice them to hold less liquid and more price-sensitive securities
Liquidity preference theory
A theory that states that treasury securities are divided into market segments by the various financial institutions investing in the market, and hte demand for various term securities is dependent on the deamnds of these segmented groups investors
Market segmentation theory
A theory that explains yields on long-term securties as a function of short-term rates; long-term rates reflect hte average of short-term expected rates over the time perido that hte long-term security will be outstanding
Expectations theroy
a measure the describes the risk of an investment project relative to other investments in general
beta coefficient
A financial instrument or contract whose value is derived from some other financial measure and includes payment provisions (ex. options, forwards, futures, etc.)
Derivative
An option of a swap that provides the holder with the right to enter into a swap at a specified future date with specified terms, or to extend or terminate the life of an existing swap (have characteristics of both options and interest rate swaps)
Swaption
The risk of loss from ineffective hedging activities
Basis risk
The risk of loss from a legal or regultaory action that invalidates or otherwise precludes performance by one or both parties to the derivative agreement
Legal risk
The method is used to determine the fair value of interest rate swaps—net settlements from the swap are estimated and discountedback to their current value and used for financial reporting purposes
zero-coupon method
A position in which a firm is committed to sell something it does not own
short position
a technique used to evaluate and control long-term investments; 6 stages
capital budgeting
Stage of capital budgeting where management determines the type of capital projects that are necessary to achieve management’s objectives and strategies
Identification stage
Stage of capibal budgeting where managment attempts to identify alternative capital investments that will achieve management’s objectives
Search stage
Stage of capital budgeting where management attempts to revaluate the various investments in terms of their costs and benefits
Information-acquisition stage
Capitabl budgeting stage where management chooses the projects that best meet the criteria established
Selection stage
The capital budgeting stage where management decides on the best source of funding for hte project
Financing stage
Capital budgeting stage wehre management undertakes the project and monitors hte performance of the investment
Implementation and control stage
Costs that will not continue ot be incurred if a department or product is terminated
Avoidable costs
Costs that arise from a company’s basic commitment ot open its doors and engage in business (depr, property taxes, salaries, etc.)
committed costs
Fixed costs whose level is set by current managment decisions
Discretionary costs
future costs that will change as a result of a specific decision
Relevant costs
The difference in costs between two alternatives
Differential (incremental) cost
The maximum income or savings foregone by rejecting an alternative
Opportunity cost
cash disbursement associated with a specific project
Outlay (out-of-pocket) costs
Investment decision method that evaluates investments based on the legnth of time until recapture (return) of the investment
Payback method
Payback method except the payback period is calculated by first discounted cash flows to their present value
Discounted payback method
Investment decision method that computes an approximate rate of return which ignores the time value of money; often used to evaluate mangement
Adjusted Rate of Return (ARR) method
Investment decision method that uses a discountedcash flow method that calculates the present value of the future cash flows of a project and compares this with the investment outlay required to implement hte project
Net Present Value (NPV) method
Discounted cash flow method that determines the rate of discount at which the present valueof hte future cash flows will exactly equal the investment outlay
Internal Rate of Return (IRR) method
The firm’s minimum acceptable rate of return for a project; determined based on the market rate of return for projects with similar risk levels
Hurdle rate
(standard deviation)/ (expected value of hte investment)
coefficient of variation
Exploring “what-if” situations ot determine the variables to which the outcomes are particularly sensitive
Sensitivity analysis
A more complex version of sensitivity analysis where managmenet develops scenarios that might happen if a number of related variables change
Senario analysis
An investment decision technique that asssumes that once managmeent makes an initial investment, it has an option to take a number of future actions that will change the value of the investment, so the initial decision can be viwed as purchasing an option
Real options
A real option for managment to expand the investment
Expansion option
A real option for management to abandon a project
Abandonment option
A real option in which management may receive other investment opportunities when investing in the project
Follow-up investment options
A real option in which managment may be provided with the ability to take advntages of changes in economic circumstances
Flexibility options
