Finance: Time Value, Bonds, Stocks, and Capital Budgeting

Time Value of Money (TVM)

The idea that a dollar today is worth more than a dollar later because you can invest it and earn interest.

Present Value (PV)

How much a future amount of money is worth today when discounted at a certain rate.

Future Value (FV)

How much money today will grow to in the future after earning interest.

Compounding

Interest earned on both the original amount and on previously earned interest. 'Interest on interest.'

Discounting

The process of figuring out what future money is worth today. Opposite of compounding.

Annuity

A series of equal payments made at regular intervals (like $500 every year).

Ordinary Annuity

Equal payments made at the end of each period.

Annuity Due

Equal payments made at the beginning of each period.

Perpetuity

Payments that continue forever with no end.

Effective Annual Rate (EAR)

The actual annual interest rate after considering compounding periods. Shows the real yearly return.

Nominal Rate

The stated interest rate (not including compounding). Used for quoting loan or investment rates.

Periodic Rate

The interest rate for each compounding period (nominal rate divided by number of periods).

Amortization

Loan repayment where each payment includes interest + principal, slowly reducing the amount owed.

Capital Market

A marketplace for long-term investments like stocks and bonds.

Money Market

A marketplace for short-term borrowing and lending (less than 1 year), like Treasury bills or commercial paper.

Primary Market

Where companies sell new securities directly to investors to raise money (ex: IPO).

Secondary Market

Where existing securities are traded between investors (ex: NYSE, NASDAQ).

Mutual Fund

A professionally managed investment fund that pools money from many investors.

Institutional Investor

Large organizations (pension funds, hedge funds, insurance companies) that trade huge amounts of money.

Retail Investor

Everyday individual investors.

SEC

Government agency that regulates financial markets to prevent fraud and require companies to disclose important information.

Insider Trading

When someone trades a stock using information not available to the public. Illegal.

Yield Curve

A graph that shows interest rates for different bond maturities (short-term vs long-term).

Prospectus

Document that provides required information to investors before a company sells securities.

IPO

When a private company sells shares to the public for the first time.

Real Risk-Free Rate

The return investors would earn with zero inflation and zero risk. Represents pure time value of money.

Inflation Premium

Extra return investors want because inflation reduces purchasing power.

Default Risk Premium

Extra return investors demand because a borrower might not make payments.

Liquidity Risk Premium

Extra return for investments that may be hard to sell quickly without losing value.

Maturity Risk Premium

Extra return for long-term bonds since they are more sensitive to interest rate changes.

Nominal Interest Rate

The total interest rate including all risk premiums and expected inflation.

Interest Rate Model

A breakdown of the interest rate into components: i = RFR + INFL + DRP + LRP + MRP.

Coupon Rate

The percentage of the bond's par value paid to investors each year as interest.

Yield to Maturity (YTM)

The total annual return an investor earns if the bond is held until maturity.

Current Yield

Annual coupon payment divided by the bond's current market price.

Discount Bond

A bond selling for less than its par value (market yield > coupon rate).

Premium Bond

A bond selling for more than its par value (market yield < coupon rate).

Duration

A measure of how sensitive a bond's price is to interest rate changes. Longer duration = more sensitivity.

Covenants

Rules placed in a bond contract to protect lenders by limiting what the borrower can do.

Convertible Bond

A bond that can be exchanged for shares of stock at a preset price.

Investment Grade

Bonds rated BBB or higher (lower risk of default).

Junk Bond

Bonds rated BB or below (higher risk, higher return).

Common Stock

Ownership in a company. Returns come from dividends and rising stock prices.

Preferred Stock

Hybrid between a stock and bond. Pays fixed dividends and has priority over common stock, but usually no voting rights.

Dividend Discount Model

A way to value a stock by estimating future dividends and discounting them to present value.

Gordon Growth Model

Simplified valuation assuming constant dividend growth: P0 = D1 / (k - g).

Intrinsic Value

What a stock is truly worth based on cash flows, not market price.

Retention Ratio

% of earnings kept in the business for growth.

Payout Ratio

% of earnings paid out as dividends.

Capital Gain Yield

The percentage increase in stock price expected over time (growth rate).

P/E Ratio

Price divided by earnings. Used to compare company valuations.

Market Efficiency

How quickly and accurately prices reflect available information.

Strong Form Efficiency

Prices reflect all public and private info (not realistic).

Semi-Strong Efficiency

Prices reflect all public information (most accepted form).

Weak Form Efficiency

Prices reflect only past stock price information.

Dilution

When new shares are issued, each existing share represents a smaller ownership percentage.

Cost of Capital

The return a company must earn to justify an investment or raising capital.

WACC

Weighted average cost of debt, preferred stock, and equity based on their proportions in the company.

Capital Structure

The percentage mix of debt, equity, and preferred stock a firm uses to finance itself.

Marginal Cost of Capital (MCC)

The cost of obtaining one more dollar of new capital.

Break Point

The level of new capital where MCC increases (often when retained earnings run out).

Flotation Costs

Fees and expenses associated with issuing new stock or bonds.

Cost of Debt

The effective interest rate a company pays on borrowing, adjusted for tax savings.

Cost of Preferred Stock

Dividend divided by preferred stock price.

Cost of Equity

Return investors require for owning stock. Can be found using dividend model or CAPM.

Retained Earnings

Profits a company reinvests instead of paying dividends.

Capital Budget

The amount of money a company sets aside for major investments and projects.

NPV

Difference between present value of inflows and outflows. Positive NPV means value is created.

IRR

The discount rate that makes NPV = 0. Represents project's expected rate of return.

Payback Period

How long it takes for a project to recover its initial cost from cash inflows.

Discounted Payback

Payback calculation using present value of cash flows (more accurate).

Incremental Cash Flows

Cash flows that occur only if the project is accepted.

Sunk Cost

A cost already spent that cannot be recovered. Should not affect decisions.

Opportunity Cost

The value of the best alternative you give up when making a decision.

Working Capital

Current assets minus current liabilities. Often needed to start a new project.

MACRS

U.S. tax depreciation system that speeds up depreciation to reduce taxes early.

Terminal Cash Flow

Final cash flow from ending a project, such as selling assets and recovering working capital.