IRR With two mutually exclusive projects the Internal Rate of Return measure
may conflict with the NPV rule. Why is this?
Internal rate of return favours projects with short duration
There is an inverse relationship between bond prices and interest
rates
The price of long-term bonds fluctuates more than the price of short-
term bonds for a given change in interest rates.
A stock with a beta of zero would be expected to: Have a rate of
return equal to the risk-free rate
opportunity
cost of The expected rate of return on a portfolio of securities of similar
capital for a risks as the project
risky project
annuity
Equal cash flows at equal intervals of time for a specified period of
time
can be eliminated by diversification
Unique risk
Diversifiabl idiosyncratic risk, firm specific risk
e risk
CAPM
(Capital Security Market Line
Asset
Pricing
Model)
efficient It implies that prices reflect all available information
market
hypothesis
abnormal
stock return Actual stock return - expected stock return
put option gives the owner the right but not the obligation to sell an asset at a
given price
if the stock price on the exercise date exceeds the exercise price,
The owner will not exercise his option
Suppose an investor buys one share of stock and a put option on
the stock. What will be the value of her investment on the final
exercise date if the stock price is below the exercise price?
The exercise price
European the value of a call plus the present value of the exercise price is
options equal to the value of a put plus the value of a share
Counter associated with a forward contract
party risk
, perpetuity Equal cash flows at equal intervals of time forever
sustainable a function of ROE and the Retention Ratio
growth rate
in dividends
Correlation A statistical measure of the degree to which securities’ returns move
Coefficient together
security’s The change in the rate of return on the security for a given change
beta in the market return
market Strong form market efficiency states that the market incorporates all
efficiency information in the stock price. Strong form efficiency implies that a
corporate insider cannot outperform the market by trading on inside
information
underlying If the underlying stock pays a dividend before the expiration of any
stock options, this will increase the value of puts and decrease the value
of calls
Buying a = Buying a call option, investing the present value of the exercise
put price in the risk-free rate, and short selling the underlying share
Forward The seller of a forward contract agrees to deliver a product at a later
contract date for a price set today
Dividend the dividends are growing at a constant rate g forever;
discount r>g
model
(DDM)
Return on Return on equity is a historical measure = EPS/Book Value of Equity
equity >< Expected (or required) return on an asset is the return that an
expected investor expects or requires on the investment, as determined by an
return on asset pricing model such as the CAPM. It is the opportunity cost of
financial capital.
security
annual Annual interest start high while the loan balance is high, and
interest repayments are low, but as the outstanding value of the loan falls,
payment interest payments decrease and repayments increase.
and
annual
principal
repaymen
ts
T The rate of exchange between future consumption and current consumption is
the pure rate of interest.
The CML has a slope of –(1+r) and shows the rate at which current
consumption can be exchanged for future consumption
T The effective annual interest rate (or Annual Percentage Rate, APR)
will be higher than the quoted (or stated) annual interest rate if
interest is compounded more frequently than once a year.
may conflict with the NPV rule. Why is this?
Internal rate of return favours projects with short duration
There is an inverse relationship between bond prices and interest
rates
The price of long-term bonds fluctuates more than the price of short-
term bonds for a given change in interest rates.
A stock with a beta of zero would be expected to: Have a rate of
return equal to the risk-free rate
opportunity
cost of The expected rate of return on a portfolio of securities of similar
capital for a risks as the project
risky project
annuity
Equal cash flows at equal intervals of time for a specified period of
time
can be eliminated by diversification
Unique risk
Diversifiabl idiosyncratic risk, firm specific risk
e risk
CAPM
(Capital Security Market Line
Asset
Pricing
Model)
efficient It implies that prices reflect all available information
market
hypothesis
abnormal
stock return Actual stock return - expected stock return
put option gives the owner the right but not the obligation to sell an asset at a
given price
if the stock price on the exercise date exceeds the exercise price,
The owner will not exercise his option
Suppose an investor buys one share of stock and a put option on
the stock. What will be the value of her investment on the final
exercise date if the stock price is below the exercise price?
The exercise price
European the value of a call plus the present value of the exercise price is
options equal to the value of a put plus the value of a share
Counter associated with a forward contract
party risk
, perpetuity Equal cash flows at equal intervals of time forever
sustainable a function of ROE and the Retention Ratio
growth rate
in dividends
Correlation A statistical measure of the degree to which securities’ returns move
Coefficient together
security’s The change in the rate of return on the security for a given change
beta in the market return
market Strong form market efficiency states that the market incorporates all
efficiency information in the stock price. Strong form efficiency implies that a
corporate insider cannot outperform the market by trading on inside
information
underlying If the underlying stock pays a dividend before the expiration of any
stock options, this will increase the value of puts and decrease the value
of calls
Buying a = Buying a call option, investing the present value of the exercise
put price in the risk-free rate, and short selling the underlying share
Forward The seller of a forward contract agrees to deliver a product at a later
contract date for a price set today
Dividend the dividends are growing at a constant rate g forever;
discount r>g
model
(DDM)
Return on Return on equity is a historical measure = EPS/Book Value of Equity
equity >< Expected (or required) return on an asset is the return that an
expected investor expects or requires on the investment, as determined by an
return on asset pricing model such as the CAPM. It is the opportunity cost of
financial capital.
security
annual Annual interest start high while the loan balance is high, and
interest repayments are low, but as the outstanding value of the loan falls,
payment interest payments decrease and repayments increase.
and
annual
principal
repaymen
ts
T The rate of exchange between future consumption and current consumption is
the pure rate of interest.
The CML has a slope of –(1+r) and shows the rate at which current
consumption can be exchanged for future consumption
T The effective annual interest rate (or Annual Percentage Rate, APR)
will be higher than the quoted (or stated) annual interest rate if
interest is compounded more frequently than once a year.
