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1 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. 2 3 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. 4 5 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. 6 7 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. 8 9 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. 10 11 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. 12