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Finance 331: Principles of Financial Management
KEY WORDS & EXAMPLES (CHAPTERS 5-9, 13, 14)
CHAPTER 5-6:
Introduction to Valuation: The Time Value of Money
Future Value (PV): The amount an investment is worth after one or more periods.
Compounding: The process of accumulating interest on an investment over time to earn more interest.
Interest on Interest: Interest earned on the reinvestment of previous interest payments.
Compound Interest: Interest earned on both the initial principal and the interest reinvested from prior
periods.
Simple Interest: Interest earned only on the original principal amount invested.
Present Value (PV): The current value of future cash flows discounted at the appropriate discount rate.
Discount: 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.
Discounted Cash Flow Valuation
Perpetuity: An annuity in which the cash flows continue forever.
Stated Interest Rate: The interest rate expressed in terms of the interest payment made each period.
Effective Annual Rate (EAR): The interest rate expressed as if it were compounded once per year.
Annual Percentage Rate (APR): The interest rate charged per period multiplied by the number of periods
per year.
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CHAPTER 7:
Interest Rates and Bond Valuation
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 called Par Value.
Coupon Rate: The annual coupon divided by the face value of a bond.
Maturity: The specified date on which the principal amount of a bond is paid.
Yield to Maturity (YTM): The rate required in the market on a bond.
Current Yield: A bond’s annual coupon divided by its price.
Note: An unsecured debt, usually with a maturity under 10 years.
Call Provision: An agreement giving the corporation the option to repurchase a bond at a specified price
prior to maturity.
Call Premium: The amount by which the call price exceeds the par value of a bond.
Bid Price: The price a dealer is willing to pay for a security.
Ask Price: The price a dealer is willing to take for a security.
Bid-Ask Spread: The difference between the bid price and the ask price.
Real Rates: Interest rates or rates of return that have been adjusted for inflation.
Nominal Rates: Interest rates or rates of return that have not been adjusted for inflation.
Fisher Effect: The relationship between nominal returns, real returns, and inflation.
Term-Structure of Interest Rates: The relationship between nominal interest rates on default-free, pure
discount securities and time to maturity.
Inflation Premium: The portion of a nominal interest rate that represents compensation for expected
future inflation.
Interest Rate Risk Premium: The compensation investors demand for bearing interest rate risk.
Default Risk Premium: The portion of a nominal interest rate or bond yield that represents
compensation for the possibility of default.
Taxability Premium: The portion of a nominal interest rate or bond yield that represents compensation
for unfavorable tax status.
Liquidity Premium: The portion of a nominal interest rate or bond yield that represents compensation
for lack of liquidity.
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CHAPTER 8:
Stock Valuation
Dividends: Payments by a corporation to shareholders, made in either cash or stock.
Dividend Growth Model (DGM): A model that determines the current price of a stock as its dividend
next period divided by the discount rate less the dividend growth rate.
Dividend Yield: A stock’s expected cash dividend divided by its current price.
Capital Gains Yield: The dividend growth rate, or the rate at which the value of an investment grows.
Common Stock: Equity without priority for dividends or in bankruptcy.
Preferred Stock: Stock with dividend priority over common stock, normally with a fixed dividend rate,
sometimes without voting rights.
Primary Market: The market in which new securities are originally sold to investors.
Secondary Market: The market in which previously issued securities are traded among investors.
Dealer: An agent who buys and sells securities from inventory.
Broker: An agent who arranges security transactions among investors.
Over-the-Counter (OTC) Markets: Securities market in which tracing is almost exclusively done through
dealers who buy and sell for their own inventories.
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CHAPTER 9:
Net Present Value and Other Investment Criteria
Net Present Value (NPV): The difference between an investment’s market value and its cost.
Discounted Cash Flow (DCF) Valuation: The process of valuing an investment by discounting its future
cash flows.
Payback Period: The amount of time required for an investment to generate cash flows sufficient to
recover its initial cost.
Discounted Payback Period: The length of time required for an investment’s discounted cash flows to
equal its initial cost.
Internal Rate of Return (IRR): The discount rate that makes the NPV of an investment zero.
Mutually Exclusive Investment Decisions: A situation in which taking one investment prevents the taking
of another.
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CHAPTER 13:
Return, Risk, and The Security Market Line
Expected Return: The return on a risky asset expected in the future.
Portfolio Weight: The percentage of a portfolio’s total value that is invested in a particular asset.
Systematic Risk: A risk that influences a large number of assets; also called market risk.
Unsystematic Risk: A risk that affects at most a small number of assets; also called unique or assetspecific risk.
Principle of Diversification: Spreading an investment across a number of assets will eliminate some, but
not all, of the risk.
Systematic Risk Principle: The expected return on a risky asset depends only on that asset’s systematic
risk.
Beta Coefficient: The amount of systematic risk present in a particular risky asset relative to that in an
average risky asset.
Security Market Line (SML): A positively sloped straight line displaying the relationship between
expected return and beta.
Market Risk Premium: The slope of the SML – the difference between the expected return on a market
portfolio and the risk-free rate.
Capital Asset Pricing Model (CAPM): The equation of the SML showing the relationship between
expected return and beta.
Cost of Capital: The minimum required return on a new investment.
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CHAPTER 14:
Cost of Capital
Cost of Equity: The return that equity investors require on their investment in the firm.
Cost of Debt: The return that lenders require on the firm’s debt.
Weighted Average Cost of Capital (WACC): The weighted average of the cost of equity and the after-tax
cost of debt.
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