Real interest rate is the nominal interest rate minus the inflation rate. When used as a forward looking tool, the inflation rate must be estimated, meaning there might be discrepancies between real interest rates by different parties. The nominal interest rate does not take inflation into account. It is just the return on the principle over the principle per annum.
Market risk is the level of risk a portfolio or investment faces due to fluctuations in the market. These are the risks faced due to factors such as GDP growth or inflation. Total risk is the risk faced from market risk as well as the unique risk. Unique risk is the risk an investment faces due to its own situation, such as competitors or their own cost levels.
The expected rate of return is dependent on the proportion of the portfolio dependent on each share. This is because one step in calculating the number is multiplying the expected rate of return for each type of share by its proportion. Riskiness is dependent on the proportion as well, as there is the unique risk faced by each investment, and the investments carrying more unique risk will bring more risk to the portfolio as their share of it increases.
The CAPM is a model that can be used to determine the rate of return required to make a given investment worth adding to a larger portfolio. The model assumes large degrees of economic rationality and being able to act properly in one’s own self interest, including that they are economically self interested and have protected themselves from risk. They must also not be influential enough to influence prices, instead being price takers. Also, it assumes little outside influence, meaning no money is lost to tax and an unlimited borrowing ability at a certain rate.
PPE is more analyzed due to the extra types of risk that therefore require more analysis.
Time value of money analysis must be used to account for the fact that money in the future is not as good as money in the present. This is due to the expected lowered purchasing power of money in the future. Also other investments making a return cannot be undertaken if the money is not available in the future. Time value of money therefore adjusts the concept of opportunity cost.
Step one is to project future cash flows. Next, compute the discount rate which is the weighted average cost of capital, which is the ratio between the total cost of equity and cost of debt. This is used to discount the projected cash flows, and then subtract the liabilities from that to get the value of an investment.
Financial assets are evaluated by projecting the cash flows of the assets. The cash flows are then discounted until all numbers are in present value. These values are them summed to give an estimated value of the asset.
Opportunity cost is the value of the things given up to pursue another action. In financial terms, opportunity cost is what was given up when one investment opportunity was passed up in favor of another.
A perfect capital market is one that does not feature transaction costs, risks of bankruptcy wiping out payments due to the asset holder, and perfect information for all actors. This is used as a way to determine the value of a company independent of its capital structure.
A bond is a loan that features the repayment of principle and interest at a certain schedule. The person holding the bond is a creditor and does not get equity in the party he has lent the money to.
The EMH states that investors cannot achieve a higher rate of return than the market rates without taking on a larger share of risk. Weak form efficiency states that prices will differ from equilibrium without allowing investors to profit from this due to the difficulty in predicting. Semi strong form states that prices adjust so quickly with new information that no one can profit by acting quickly with information. Finally, strong-form is the theory that share prices are always at equilibrium with open information, meaning there are no inefficiencies to find.
Common stock is the standard understood form of stock where the paying of dividends can vary, leading to higher risk and higher potential for returns than preferred stock, where the terms include specific pre determined dividend payouts.
NPV is net present value, the total of present values amongst all entities. It calculates whether or not the investment is a worthy venture by comparing the present value of the investment’s cash flows to the purchase price that must be paid out immediately. Those with a higher present value than the cost, a positive net present value, should be undertaken. If two or more investments are mutually exclusive, the one with the highest NPV should be undertaken.
Capital budgeting is a process that attempts to assess the worthiness of an investment in a piece of capital. A net present value is calculated and compared to a benchmark return for investments. Risk is the chance that the capital will have a lower return than expected and can be adjusted for with a higher discount rate when calculating the NPV.
Stand alone risk, the risk found in a single asset. Corporate risk, which is the risk when investing in an entire company based on that company’s volatility, and market risk where the overall economy can affect the investment and harm its profitability.
Each type of risk is largely based on subjective judgments as it is difficult to predict risk only through historical numerical data.