Law of One Price and Financial Decision Making Flashcards
Valuation Principle
When the value of the benefits of a decision exceeds the cost of the project, then the project will increase the market value of the firm
Risk Free rate
the interest rate that we can borrow at without a risk
discount factor
1/ (1+r)
Discount rate
when we are discounting fugure values back to the present value the interest rate that we use is referred to as the discount rate
Net Present Value
The Present Value of the benefits minus the present value of the costs, a positive NPV means that we accept the project
Arbitrage
the buying and selling of equivalent goods in different markets to take advantage of a price difference
normal market
a market where there are no arbitrage differences
the Law of One Price
if equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets
No Arbitrage Price
the no arbitrage price is the present value of all cash flows paid by the security
Separation Principle
we can evaluate the NPV of an investment decision separately from the decision the firm makes regarding how to finance the investment or any other security transactions the firm is considering
we evaluate the projects based on the risks of the projects themselves
portfolio
a collection of investments
value additivity
the value of a whole group of assets exactly equals the sum of the values of the individua assets
Value additivity and firm value
the value of the firm is maximized if the value of each part of the firm is maximized
expected returns of investments
the weighted average of the potential returns of the investments
Risk premiums
risk premium is the difference between the expected return of an investment and the risk free rate
