Time Value of Money & Discounted Cash Flow Valuation
Present value (PV) - The current value of future cash flows discounted at the appropriate discount rate.
Discounting - Calculate the present value of some future amount.
Discount rate - The rate used to calculate the present value of future cash flows.
Discounted cash flow (DCF) valuation - Calculating the present value of a future cash flow to determine its value today.
An investment should be accepted if the net present value is positive and rejected if it is negative.
Internal Rate of Return (IRR) - The discount rate that makes the NPV of an investment zero.
The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate.
Annuity - A level stream of cash flows for a fixed period of time.
Perpetuity - An annuity in which the cash flows continue forever.
Annual percentage rate (APR) - The interest rate charged per period multiplied by the number of periods per year.
Sinking fund - An account managed by the bond trustee for early bond redemption.
Sunk cost - A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.
Erosion - The cash flows of a new project that come at the expense of a firm’s existing projects.
Payback period - The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.
Operating leverage is the degree to which a project or firm is committed to fixed production costs. A firm with low operating leverage will have low fixed costs compared to a firm with high operating leverage. Generally speaking, projects with a relatively heavy investment in plant and equipment will have a relatively high degree of operating leverage. Such projects are said to be capital intensive.
Degree of operating leverage (DOL) - The percentage change in operating cash flow relative to the percentage change in sales.
Interest rates, yields & bonds
Bonds - When a corporation (or government) wishes to borrow money from the public on a long-term basis, it usually does so by issuing or selling debt securities that is generically called bonds.
Coupon - The stated interest payment made on a bond.
Face value - The principal amount of a bond that is repaid at the end of the term. Also, par value.
Coupon rate - The annual coupon divided by the face value of a bond.
Maturity - Specified date on which the principal amount of a bond is paid. Zero coupon bond - A bond that makes no coupon payments, thus initially priced at a deep discount.
Government Bonds - When the government wishes to borrow money for more than one year, it sells what are known as Treasury notes and bonds to the public.
Yield to maturity (YTM) - The rate required in the market on a bond.
Current yield - A bond’s coupon payment divided by its closing price.
Interest Rate Risk
The risk that arises for bond owners from fluctuating interest rates is called interest rate risk. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes. This sensitivity directly depends on two things: the time to maturity and the coupon rate. As we will see momentarily, you should keep the following in mind when looking at a bond:
1. All other things being equal, the longer the time to maturity, the greater the interest rates risk. 2. All other things being equal, the lower the coupon rate, the greater the interest rates risk.
Equity - As a general rule, equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt holders. As a result of this, the risks and benefits associated with owning debt and equity are different.
Nominal rates - Interest rates or rates of return that have not been adjusted for inflation.
Real rates - Interest rates or rates of return that have been adjusted for...
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