39 Cards in this Set
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Capital budgeting
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the process of making long-term investment decisions
decision making process that enables a firm to evaluate the viability of a long-term project and whether it is worth undertaking
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Independent projects
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when the cash flows of one project are unaffected by the acceptance of another
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Mutually exclusive projects
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a set of projects where only one can be accepted
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Incremental earnings
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amount by which a firm's earnings are expected to change as a result of an investment decision
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Sunk costs
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historical costs that are not relevant to the investment decision
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Cannibalization
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when a new product line decreases the sales of the firm's other product lines
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depreciable basis
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the fully installed cost of an asset --> amount you can write off on taxes (installation, delivery)
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Capitalized expenditures
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expenditures that may provide benefits into the future and therefore are treated as capital outlays and not as expenses of the period in which they were incurred (e.g shipping & installation)
Written off over the product's life
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Book value
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the depreciable basis of the asset less its accumulated depriciation
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straight line depreciation
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the same amount each year is depreciated over the economic life of the asset
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MACRS depreciation
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the amount depreciated is dependent on a provided MACRS schedule in which more of the value of the asset is depreciated in the yearly years of its economic life
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Salvage value
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the market value of an asset at the time of sale
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intrinsic value
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represents the true value of the company's stock -- what the price should be in perfect world
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stock price
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the current market value of the stock
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Free cash flow
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measures the cash generated by the firm before any payments to debt- or equity-holders are considered
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weighted average cost of capital
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appropriate discount rate to use when discounting the FCF of the firm
cost of capital that reflects the risk of the overall business, which is the combined risk of the firm's equity and debt
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Terminal enterprise value
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enterprise value of the firm immediately prior to the start of constant growth of the FCF
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When to use Discounted Free Cash Flow Model
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Preferred to the dividend growth model since many firms don't pay dividends or they are hard to forecast
Similar to dividend growth model, assumes at some point FCF will grow at a constant rate
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Method of comparables
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the value of the firm is based on the value of other comparable firms or investments that we expect will generate very similar cash flows in the future
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Valuation multiples
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a ratio of a firm's value to some measure of the firm's scale or cash flow
P/E Ratio, Enterprise Value Multiples, etc.
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Limitations of Multiples
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Firms are not identical
Differences in multiples can be related to differences in
expected future growth rate
risk (cost of capital)
differences in accounting conventions between countries
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Efficient markets hypothesis
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Implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors
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Public, easily accessible info
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info available to all investors includes info in news reports, financial statements, corporate press releases, or other public data sources
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Overconfidence hypothesis
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tendency of individual investors to trade too much based on the mistaken belief that they can pick winners and losers better than investment professionals
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Disposition effect
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investors tend to hold on to stocks that have lost value and sell stocks that have risen in value, reflects reluctance to admit a mistake by taking the loss
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Investors Attention, Mood & Experience
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Investors are not generally full-time traders, they have limited time and attention
More likely to buy stocks in the news, advertised more, etc.
Stock exchange is higher on sunny days than on cloudy days
Investors put too much weight on their own experiences
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Risk
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probability of not receiving the expected return from an investment
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risk-return trade-off
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to entice investors to take more risks, you have to provide them with a higher expected return
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Stand-Alone Risk
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the risk an investor would face if he/she held only one investment
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Historical realized rate of return
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total return earned over a particular period
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Coefficient of variation
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standardized measure of dispersion about the expected value that shows the risk per unit of return
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Systematic risk
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portion of a security's stand-alone risk that cannot be eliminated through diversification
Ex: Recession, 9/11
AKA Common risk
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Unsystematic risk
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portion of a security's stand-alone risk that can be eliminated through proper diversification
AKA independent risk
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Diversification
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averaging out of independent/unsystematic risks in a large portfolio
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Portfolio weights
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fraction of the total investment in a portfolio held in each individual investment in the portfolio -- adds up to 100%
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return of portfolio
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weighted average of the returns on the investments in a portfolio, where the weights correspond to the portfolio weights
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Volatility
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total risk of a portfolio measured by SD
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correlation
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ranges from -1 to +1 and measures the degree to which the returns share common risk
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Beta
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the expected percentage change in the excess return of a security for a 1% change in the excess return of the market portfolio
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Study Guide: Exam 3