Finance Final Test

A collection of vocabulary flashcards that define key concepts related to investment evaluation and risk management.

Replacement Projects

Investments made to replace existing assets with newer, more efficient ones to reduce costs or maintain operations.

Expansion Projects

Investments intended to increase production or service capacity in response to growing demand.

Dispersion Projects

Projects that involve geographic expansion to reduce dependency on a single market or location.

Diversification Projects

Investments in new products, services, or markets that differ from the company’s existing operations.

Elimination of Project Dependencies

The process of identifying and removing interdependencies between projects to enable clearer evaluation and independent execution.

Incremental Cash Flows

Only include cash flows that occur because of the project, excluding sunk costs but including opportunity costs.

Sunk Costs

Costs that have already been incurred and cannot be recovered, not included in project evaluation.

Opportunity Costs

The benefits lost by choosing one alternative over another, included in incremental cash flow analysis.

Initial Investment

All cash outflows at the start of the project, such as equipment, installation, and working capital needs.

Operating Cash Flows

Recurring annual cash flows from the operation of the project, typically revenues minus expenses and taxes.

Termination Cash Flows

Final cash inflows/outflows when the project ends, including salvage value and recovery of working capital.

Net Present Value (NPV)

The present value of all project cash flows minus the initial investment; acceptable if NPV > 0.

NPV Formula

NPV=∑CFt(1+r)t−Initial Investment where CFt is cash flow in period t and r is the discount rate.

Internal Rate of Return (IRR)

The discount rate that makes NPV = 0; acceptable if IRR > required return.

Mutually Exclusive Projects

Choosing one project prevents doing another; select the one with the highest NPV.

Payback Period

Time it takes for a project to recover its initial investment from cash inflows.

Real Options in Projects

Flexibility in investment decisions, such as the option to delay, expand, abandon, or pause a project.

Required Return – Components

1. Risk-Free Rate 2. Risk Premium.

Risk–Return Relationship

Higher risk usually leads to higher expected return.

Average Return

Sum of annual returns divided by the number of years.

Stock Risk – What Determines It?

Volatility of returns, measured by standard deviation (SD).

Standard Deviation (SD)

A measure of total risk, showing how much actual returns deviate from the average.

Unique Risk vs. Systematic Risk

Unique (Unsystematic): diversifiable; Systematic: market-wide, cannot be diversified away.

Diversification

Combining different stocks to reduce unique risk in a portfolio.

Portfolio Weights

Proportion of each stock in the portfolio, based on value.

Stock Correlation

Measures how two stocks move together, ranging from -1 to +1.

Portfolio Effect

Risk reduction due to diversification; most effective with low or negative correlation.

Beta – Definition

Measures a stock’s sensitivity to market movements.

How to Calculate Beta

β=Cov(Ri,Rm)Var(Rm) or the regression slope of stock return vs. market return.

Portfolio Beta

Weighted average of the individual betas in a portfolio.

Capital Asset Pricing Model (CAPM)

E(R)=Rf+β(E(Rm)−Rf) used to estimate expected return based on risk.

Basic Investing Principle

Only invest if the Expected Value (E[V]) > Cost of the investment.

Net Present Value and E(V)

If E(V) > Cost, then NPV > 0, indicating the investment is financially viable.

E(V) < Cost

The investment destroys value and should be rejected.

E(V) = Cost

Indicates the investment breaks even, usually not attractive unless for strategic reasons.

Risk Adjustment in E(V)

Always adjust the expected value for risk when comparing to cost.