Finance Final

risk aversion

The tendency to prefer a sure gain of a moderate amount over a riskier outcome, even if the riskier outcome might have a higher expected payoff

risk loving

condition of preferring a risky income to a certain income with the same expected value

risk neutral

the attitude toward risk in which investors choose the investment with the higher return regardless of its risk

variance

average value of squared deviations from mean; a measure of volatility

standard deviation

square root of variance; a measure of volatility

asset allocation

where you invest funds

100-age

baseline of how much to invest

correlation

A measure of the extent to which two factors vary together, and thus of how well either factor predicts the other

diversified portfolios

preferred by investors because they reduce variability, therefore reducing risk

positive correlation

cannot diversify away risk from stocks with this behavior of return

specific/nonsystematic/unique/idiosyncratic risk

type of risk that can be eliminated through diversification

market/systematic risk

type of risk that cannot be eliminated through diversification

uncorrelated

the greatest benefit of diversification comes from stock with this behavior of return

contribution to portfolio risk

dependent on the relationship of the stock to the market

1.0

market portfolio beta value

2.0

beta level representing a well-diversified portfolio that is 2x as risky as the market portfolio/market risk premium

Harry Markowitz

father of modern portfolio theory

modern portfolio theory

a concept and procedure for combining securities into a portfolio to minimize risk

efficient return

set of optimal investment portfolios that offer the highest expected return for a level of given risk

William Sharpe

founded the Capital Asset Pricing Model (CAPM)

sharpe ratio

evaluates performance of an investment by adjusting for risk

capital asset pricing model (CAPM)

a model that relates the required rate of return on a security to its systematic risk as measured by beta

diversification

strategy designed to reduce risk by spreading portfolio across many investments

> 1

sharpe ratio displaying a situation in which an investment would earn more per unit of risk

= 1

sharpe ratio displaying a situation in which returns correspond with risk

< 1

sharpe ratio displaying a situation in which an investment does not provide enough return for risk taken

capital market line (CML)

the line on a graph of return and risk (standard deviation) regarding portfolios from the risk-free rate through the market portfolio

tangency portfolio

Optimal risky portfolio along the efficient frontier

market portfolio

the portfolio for which each security is held in proportion to its total market value

security market line (SML)

graphical representation of the expected return-beta relationship of the CAPM regarding individual securities

security market line equilibrium

principle stating that in equilibrium, no stock can lie below this line

below SML

location representing a stock that is overvalued, and should not be bought (Kwok would say to short this stock for some reason)

equal/above SML

location representing a stock that is undervalued, and should be bought (Kwok would say to long this stock for some reason)

negative beta

CAPM implies that if you find an investment with this beta, it's expected return would be less than interest rate

higher beta

found on stocks that lie below the SML

non-diversifiable risk

investors demand higher rates of return on stocks with more of this

0 (beta)

a security with this beta value will offer the risk free rate of return (ex: treasury bills)

macroeconomic risk

investors demand higher expected rates of return from stocks with returns that are highly susceptible to this

factor analysis

using stats to understand how different factors influence asset returns and aid in portfolio construction

4 factors

-industrial production

-shift in term structure

-change in default spread

-unanticipated inflation rate

industrial production

measure of output of industrial sector

shift in term structure

change in the yield curve

change in default spread

chance of default/bankruptcy and how it relates to investments

unanticipated inflation rate

unexpected changes in inflation rate

arbitrage pricing theory (or model)

a theory of risk-return relationships derived from no-arbitrage considerations in large capital markets

Fama & French

Market phenomena can be explained as manifestations of risk premiums (3-factor model)

price-book value ratio

compares the company's market price to its book value per share; the higher the ratio, the greater premium the public is willing to pay over the intrinsic value of the enterprise

sources of investment ideas

-market trends

-competitors actions

-consumer demand/needs

-stakeholder ideas/thoughts

-innovative employee ideas

profitability index

the present value of an investment's future cash flows divided by its initial cost; highest weighted average PI indicates optimal project

book rate of return

average income divided by average book value over project life

payback

choosing project that pays you back within a specified amount of time

internal rate of return (IRR)

rate of return where NPV = 0; representing cost of capital equalling investment

net present value (NPV)

displays project value based on future cash flows after initial investment; if positive, invest/if negative, do not invest

hurdle rate

rate that must be achieved to breakeven; IRR > hurdle to invest

cons of IRR

power function, multiple rates of return, ignores magnitude of project, cannot decipher mutually exclusive projects

capital rationing

allocating capital to different purposes; limiting amount of funds to invest

flotation costs

costs associated with issuing new securities to raise capital

soft rationing

limits on investments are made by managers for better control of the firm

hard rationing

funds are not available and managers must choose the best set of projects given their capital constraints

project annual tax shield

depreciation amount x tax rate equals

taxable income

depreciation does not affect cash flows, it affects .......

depreciation

non-cash expense to record wear and tear

pros to NPV

reliable benchmark, uses all forecasted future cash flows, not affected by current business status

cons to NPV

cannot compute the size of an investment decision, cash flows are not always predictable

pros to IRR

easily interpreted, utilizes the time value of money

cannabilization

a situation that occurs when a benefit to a company in one area leads to a loss in another area

sunk costs

costs that have already been incurred and cannot be recovered

Modified Accelerated Cost Recovery System (MACRS)

A depreciation method that is used for tax purposes; front-loaded

Straight Line Depreciation

Method that allocates an equal portion of the depreciable cost of plant asset (cost minus salvage) to each accounting period in its useful life; (cost - salvage value) / useful life

working capital

cash needed for circulation of liquidity

terminal value (TV)

represents all future cash flows in an asset valuation model; this allows models to reflect returns that will occur so far in the future that they are nearly impossible to forecast

incremental cash flow

the difference between the cash flows a company will produce both with and without the investment it is thinking about making

mutually exclusive projects

situation in which a company can only choose 1 out of 2 potential project choices; prioritize NPV method here

capital structure

the mix of equity and debt financing a firm uses to meet its permanent financing needs

weighted average cost of capital (WACC)

the weighted average of the cost of equity and the aftertax cost of debt

irrelevance hypothesis (modigliani and miller)

theory maintaining that firm value is independent of capital structure

costs of financial distress

reputational issues, reduction in credit, difficulties collecting receivables, asset fire sales, legal fees

residual claimant

the economic agent who receives whatever profit or loss remains (is residual) at a firm after all other input providers have been paid

range of optimal capital structure

shown on a graph, mix of debt and equity financing that minimizes cost of capital and maximizes value

cost of debt

the expected return on debt; if the debt has low default risk, this is close to yield to maturity

yield curve

relationship between interest rate and maturity

cost of equity

expected return on equity

after tax WACC

weighted average cost of equity and the after tax cost of debt (where weights are relative to market values of firm debt and equity)

equity beta

change in return on a stock for each 1% change in market return

asset beta

change in return on a portfolio of all the firm's securities (debt & equity) for each 1% change in market return

pure-play comparable

a company specializing in one activity that is similar to that of a division of a more diversified company

certainty equivalent

a certain cash flow occurring at time t with the same present value as an uncertain cash flow at time t

company cost of capital

represents the correct discount rate for new projects only if the new projects have the same risk level as the existing business

distant cash flows

utilize probability-weighted cash flows to determine potential future riskiness with these

fudge factors

adding these to discount rates undervalues long-lived projects compared with quick payoff projects

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