Fundamental Financial Principles - Unit 3

Vocabulary and key concepts from Unit 3 of the Fundamental Financial Principles course, covering Interest Rates, Time Value of Money, and Risk and Return.

Finance

A decision science in which numbers are used to make informed decisions to improve business and/or personal welfare.

Shareholder Wealth

The metric businesses seek to maximize, while individuals seek to maximize utility or satisfaction.

Interest Rate (Alternative Names)

Commonly referred to as Cost of Capital, Discount Rate, or Required Rate of Return.

Nominal Interest Rate ($i_n$) Formula

$$Nominal Interest Rate (i_{n}) = General Interest Rate + Risk Premium + Liquidity$$

General Interest Rate

Also known as the Risk Free Rate, such as the US Treasury Bond rate.

Risk Premium

A component of the nominal interest rate based on the Time Horizon of the investment and/or the probability of default.

Liquidity

The amount of difficulty encountered when attempting to convert an investment to cash.

Simple Interest

Earning interest only on the original savings amount (principal) each period.

Total Interest (Simple)

$$Total Interest = (Principal \times Interest Rate) \times t$$

Compound Interest

The process of earning "interest on interest."

Future Value (Compound Interest) Formula

$$Future Value = P \times (1 + R)^{N}$$

Required Return ("Hurdle Rate")

The compensation that a lender or an investor expects in exchange for investing in a financial security such as a bond or stock.

Risk

In finance, when outcomes differ from what is expected; greater variability in potential outcomes indicates greater risk, measured by Standard Deviation.

Inflation

The rate at which the average price of a basket of goods and services increases over a time period, causing the purchasing power of money to decline.

Opportunity Cost

The alternative potential gain that is given up when choosing one specific option over another.

Demand "Pull" Inflation

A cause of inflation that occurs when demand exceeds supply.

Cost "Push" Inflation

A cause of inflation that occurs when the costs of materials increase.

Built-In Inflation

A cause of inflation that occurs when employees demand higher wages.

Real Rate Formula

$$Nominal Rate - Inflation = Real Rate$$

Time Value of Money (TVM)

A concept stating that a dollar today is worth more than a dollar tomorrow due to consumption preferences, monetary inflation, and uncertainty or risk.

Rate (Excel Input)

The interest rate per period used in financial functions.

Nper (Excel Input)

The total number of payment periods in a financial calculation.

Pmt (Excel Input)

A recurring cash flow amount that occurs every period, such as a monthly loan payment.

PV (Excel Input)

The present value, representing a single cash flow amount that occurs at the beginning of the period.

FV (Excel Input)

The future value, representing a single cash flow amount that occurs at the end of the period.

Type (Excel Input)

Indicates when payments are due: 0 for the end of the period (default) or 1 for the beginning of the period.

Compounding

The process of determining the future value of a cash flow.

Discounting

The process of determining the present value of an expected future cash flow.

Annuity

A series of equal dollar amounts paid or received at equidistant points in time over a finite period.

Ordinary Annuity

An annuity where the cash flows occur at the end of each period.

Annuity Due

An annuity where the cash flows occur at the beginning of each period.

Net Present Value (NPV)

An Excel function used to find the present value of a set of uneven future cash flows.

Internal Rate of Return (IRR)

An Excel function used to determine the rate earned on an investment made today that will generate future cash flows.

Return

The gain or loss on an investment over a period of time, commonly expressed as a percentage ($\%$).

Holding Period Return (HPR)

The "Actual Return" from the past, calculated as $(Ending Value - Beginning Value) / Beginning Value$. Also known as Return on Investment (ROI).

Expected Return

A weighted return based on probabilities and historical averages that an investor expects to receive in the future.

Standard Deviation

In finance, the measure used to quantify the amount of risk by determining how far an outcome deviates from the expected standard.

Systematic Risk

Risk that is inherent to the entire market, also known as Market Risk, Nondiversifiable Risk, or Beta.

Unsystematic Risk

Risk that is specific to a single firm, also known as Firm Specific Risk, Diversifiable Risk, or Idiosyncratic Risk.

Time Diversification

The principle that stock investments are less risky over a longer period of time than over a short period of time.

Risk Management Methods

Approaches to managing risk including Reduction, Diversification, Separation, Transfer, Retention, and Avoidance.