MASTER Set

Face Value

The principal amount of a bond repaid at maturity; also called par value; typically $1,000

Coupon

The periodic interest payment made by a bond issuer; equals coupon rate times face value divided by payments per year

Coupon Rate

The annual interest rate stated on a bond as a percentage of face value; fixed at issuance and never changes

Yield to Maturity (YTM)

The single discount rate that sets the PV of all promised bond cash flows equal to the current market price; quoted as an APR

Zero-Coupon Bond

A bond that pays no coupons and only pays face value at maturity; always trades at a discount to face value

Bond at Par

When a bond's price equals its face value; occurs when the coupon rate equals the YTM

Bond at Premium

When a bond's price exceeds its face value; occurs when the coupon rate is greater than the YTM

Bond at Discount

When a bond's price is below its face value; occurs when the coupon rate is less than the YTM

Pull to Par

The tendency of a bond's price to converge to face value as maturity approaches; holds regardless of whether bond started at premium or discount

Interest Rate Risk

The risk that bond prices fall when interest rates rise; longer maturity and lower coupon rate both increase sensitivity

Credit Risk

The risk that a bond issuer defaults and fails to make promised payments; compensated through lower price and higher YTM

Credit Spread

The difference between a corporate bond's YTM and an equivalent risk-free bond's YTM; reflects default risk premium

YTM vs Expected Return

YTM is calculated using promised cash flows and overstates expected return when default is possible; higher YTM does not guarantee higher expected return

Bond Rating

An assessment of a bond issuer's creditworthiness by agencies like S&P or Moody's; lower rating means higher default risk, higher YTM, lower price

Call Option

A contract giving the right but not the obligation to buy an asset at the strike price on or before expiration; exercised when stock price exceeds strike price

Put Option

A contract giving the right but not the obligation to sell an asset at the strike price on or before expiration; exercised when strike price exceeds stock price

Strike Price

The fixed price at which the underlying asset can be bought (call) or sold (put); also called the exercise price

Option Premium

The price paid today to purchase an option; represents the maximum loss for the buyer of the option

European Option

An option that can only be exercised on the expiration date; put-call parity applies only to European options

American Option

An option that can be exercised at any time up to and including the expiration date; always worth at least as much as the equivalent European option

In the Money

An option whose immediate exercise would produce a positive payoff; call: stock price above strike; put: stock price below strike

Out of the Money

An option whose immediate exercise would produce a negative payoff — it is not exercised; still has positive value before expiration due to time value

Volatility and Option Value

Higher volatility increases the value of both calls and puts; options benefit asymmetrically from large moves since the downside is capped at the premium paid

Put-Call Parity

The relationship S0 + P0 = K/(1+rf)^T + C0; holds for European options only; used to find any one price given the other three

Delta

The number of shares needed to replicate one call option in the binomial model; equals (CU minus CD) divided by (SU minus SD); always between 0 and 1 for calls

Replicating Portfolio

A portfolio of shares and risk-free borrowing that produces the same payoffs as an option in all scenarios; used to price options by arbitrage

Binomial Option Pricing

Values a call by finding the cost of the replicating portfolio; price equals delta times stock price minus amount borrowed; put price found via put-call parity

Cost of Capital

The minimum return a firm must earn on an investment to satisfy all its investors; reflects the risk of the investment, not the firm

Cost of Equity

The return required by equity investors; estimated using CAPM as rf plus beta times the market risk premium

Cost of Debt

The return required by debt holders; the pre-tax cost is the yield to maturity on existing debt

After-tax Cost of Debt

The effective cost of debt after accounting for the tax deductibility of interest; equals rD times (1 minus the tax rate)

Cost of Preferred Stock

Fixed preferred dividend divided by current preferred stock price; no tax adjustment since preferred dividends are not tax deductible

WACC (Weighted Average Cost of Capital)

The blended cost of all financing sources weighted by their market value proportions; used as the discount rate for average-risk projects

Capital Structure

The mix of debt and equity a firm uses to finance its assets; weights in WACC must reflect target capital structure using market values

Market Value Weights

Weights in WACC based on current market prices of debt and equity — not book values; book value of equity is a poor proxy for market value

Target Capital Structure

The long-run debt-equity mix a firm intends to maintain; used for WACC weights regardless of how a specific project is financed

Project-Specific WACC

A discount rate tailored to a project's own risk rather than the firm's average risk; required when the project is in a different industry or has different risk

Comparable Firms

Publicly traded firms in the same business as the project; their equity betas are used to estimate the project's beta when it cannot be observed directly

Tax Shield on Debt

The reduction in taxes from deducting interest payments; makes debt cheaper than equity on an after-tax basis by a factor of (1 minus tax rate)

Net Present Value (NPV)

The difference between the present value of a project's cash inflows and outflows; the gold standard investment decision rule — accept if positive, reject if negative

Cost of Capital

The discount rate used in NPV calculations; reflects the risk of the specific project, not necessarily the firm's overall rate

Mutually Exclusive Projects

Projects where accepting one means rejecting the others; must be compared using NPV — pick the highest NPV among positive options

Equivalent Annual Annuity (EAA)

Converts a project's NPV into an equivalent fixed annual cash flow; used to compare mutually exclusive projects with different lifespans

Internal Rate of Return (IRR)

The discount rate that makes a project's NPV equal to zero; accept if IRR exceeds the cost of capital for independent projects

IRR vs NPV conflict

When mutually exclusive projects have different NPV and IRR rankings, always follow NPV — IRR ignores the scale of investment

Multiple IRRs

When a project's cash flows change sign more than once, multiple IRRs can exist, making the IRR rule unreliable

Profitability Index (PI)

NPV divided by initial investment; measures value created per dollar invested — used to rank projects under a budget constraint

Payback Period (PP)

The time required to recover the initial investment from cash flows; flawed because it ignores time value of money and cash flows after the cutoff

Reinvestment Assumption

IRR implicitly assumes intermediate cash flows are reinvested at the IRR rate; NPV assumes reinvestment at the cost of capital, which is more realistic

Scale Problem

IRR ignores the size of investment — a high IRR on a small project can look better than a lower IRR on a much larger, more valuable project

Incremental Free Cash Flow

The change in a firm's cash flows that results directly from taking a project; the only relevant cash flows for NPV calculation

Sunk Cost

A cost already incurred that cannot be recovered regardless of the decision; must always be excluded from incremental FCF

Opportunity Cost

The value of the best alternative use of a resource; must be included as a cost even if no cash changes hands

Cannibalization

When a new project reduces sales of an existing product; the after-tax lost revenue is an incremental cost of the project

Depreciation Tax Shield

The tax savings from deducting depreciation; equals depreciation times the tax rate — not a cash outflow but reduces taxes paid

Straight-Line Depreciation

Spreads asset cost evenly over useful life; annual depreciation equals (purchase price minus salvage value) divided by useful life

Book Value

Purchase price minus accumulated depreciation; used to determine capital gain or loss when an asset is sold

Capital Gain

The amount by which an asset's sale price exceeds its book value; taxed at the corporate tax rate

After-tax Salvage Value

The actual cash received when selling an asset; equals sale price minus tax on the capital gain or plus tax credit on capital loss

Net Working Capital (NWC)

Current assets minus current liabilities tied up in running the project; an outflow when it increases, recovered as inflow when project ends

Machine Replacement

A capital budgeting decision comparing incremental FCF of buying a new machine versus keeping the old one; use after-tax proceeds from selling old machine to offset Year 0 cost

Portfolio weights

Fraction of total portfolio value in each asset; must sum to 1; can be negative (short selling) or above 1 (leverage)

Mean-variance preferences

Investors prefer higher return for the same risk, or lower risk for the same return; used to rank portfolios when comparisons are unambiguous

Feasible set

All possible portfolios that can be constructed from a given set of assets by varying weights; shape depends on correlation between assets

Minimum Variance Portfolio (MVP)

The portfolio with the lowest possible variance; the leftmost point of the feasible set; divides efficient from inefficient boundary

Efficient frontier

The upper boundary of the feasible set above the MVP; all portfolios that cannot be improved without taking more risk

Capital Allocation Line (CAL)

A straight line showing all risk-return combinations from mixing a risky portfolio with the risk-free asset; slope equals the Sharpe Ratio

Sharpe Ratio

Expected return above the risk-free rate divided by standard deviation; measures return per unit of risk; the optimal CAL has the highest Sharpe Ratio

Tangent portfolio

The risky portfolio where the optimal CAL touches the efficient frontier; has the highest Sharpe Ratio; all rational investors hold it as their risky component

Market portfolio

In equilibrium, equals the tangent portfolio; contains all risky assets weighted by market value; has beta of exactly 1 by definition

Beta

Measures a security's systematic risk; equals covariance of the security with the market divided by variance of the market; portfolio beta is the weighted average of individual betas

CAPM (Capital Asset Pricing Model)

States that expected return equals the risk-free rate plus beta times the market risk premium; only systematic risk is compensated

Market Risk Premium

The difference between the expected market return and the risk-free rate; represents the reward per unit of systematic risk

Security Market Line (SML)

The graphical representation of CAPM with beta on the x-axis and expected return on the y-axis; all fairly priced assets lie on the SML

Undervalued stock

A stock above the SML — offers more return than its beta justifies; investors buy it, price rises, return falls back to SML

Overvalued stock

A stock below the SML — offers less return than its beta justifies; investors sell it, price falls, return rises back to SML

Realized Return

The actual return earned on an investment over a period; equals price change plus dividends divided by the starting price

Systematic Risk

Risk that affects the entire economy and cannot be diversified away; examples include interest rates, inflation, and recessions; the only risk that earns a return premium

Unsystematic Risk

Firm-specific risk that affects only a small number of assets and can be eliminated through diversification; earns no return premium

Diversification

The process of combining assets in a portfolio to reduce unsystematic risk; does not eliminate systematic risk

Variance

A measure of how spread out an asset's returns are around the average; computed using T-1 in the denominator from historical data

Volatility

The standard deviation of returns; same units as return (%) making it easier to interpret than variance

Covariance

Measures how two assets' returns move together; positive means same direction, negative means opposite directions; computed using T-1

Correlation

Covariance scaled by the product of the two standard deviations; always between -1 and +1; easier to interpret than covariance

Risk Premium

The expected return above the risk-free rate; determined solely by an asset's systematic risk, not its total volatility

Equity Cost of Capital

The expected return required by equity investors given the risk of the stock; the rate used to discount dividend streams

Dividend Yield

The ratio of the next expected dividend to the current stock price (Div1 / P0); represents the income portion of total return

Capital Gains Yield

The percentage change in stock price over a period ((P1 - P0) / P0); represents the price appreciation portion of total return; equals g in constant growth

Dividend Discount Model (DDM)

A stock valuation model that prices a share as the present value of all future expected dividends

Gordon Growth Model

A special case of the DDM where dividends grow at a constant rate forever; derived from the growing perpetuity formula on the sheet

Terminal Value

The estimated value of a firm at the end of a forecast horizon, calculated using a growing perpetuity; must be discounted back to today

Total Payout Model

Values equity as the present value of all future dividends and share repurchases combined, divided by current shares outstanding

Share Repurchase

When a firm buys back its own shares; equivalent in value to dividends — does not change today's stock price vs an equivalent dividend

Enterprise Value (EV)

The total market value of a firm to all investors; equals market value of equity plus debt minus cash

Free Cash Flow (FCF)

Cash available to all investors after operating expenses, taxes, and investments; ignores interest payments — discounted at WACC not rE

Discounted FCF Model

Values a firm by discounting Free Cash Flows at WACC to get Enterprise Value, then adds cash and subtracts debt to get equity value

P/E

Stock price divided by Earnings Per Share; higher for faster-growing, lower-risk, higher-payout firms

Forward P/E

Price-to-Earnings ratio using next year's expected Earnings Per Share (EPS1); derived from payout ratio divided by (rE minus g)

EV/EBITDA Multiple

Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation, and Amortization; preferred over P/E when firms have different capital structures