Term
| present discounted value (PDV) |
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Definition
| The current value of an expected future cash flow. |
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Term
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| Contract in which a borrower agrees to pay the bondholder (the lender) a stream of money. |
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Term
| Because most of the bond’s payments occur in the future, the present discounted value... |
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Definition
...declines as the interest rate increases.
For example, if the interest rate is 5 percent, the PDV of a 10-year bond paying $100 per year on a principal of $1000 is $1386. At an interest rate of 15 percent, the PDV is $749. |
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Term
| effective yield (or rate of return) |
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Definition
Percentage return that one receives by investing in a bond.
The effective yield is the interest rate that equates the present value of the bond’s payment stream with the bond’s market price. |
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Term
| net present value (NPV) criterion |
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Definition
| Rule holding that one should invest if the present value of the expected future cash flow from an investment is larger than the cost of the investment. |
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Term
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Definition
| Rate used to determine the value today of a dollar received in the future. |
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Term
| opportunity cost of capital |
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Definition
| Rate of return that one could earn by investing in an alternate project with similar risk. |
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Definition
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Term
| At discount rate R*, the NPV is |
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Definition
zero.
R* is sometimes called the internal rate of return on the investment. |
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Term
| The NPV of a factory is the |
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Definition
| present discounted value of all the cash flows involved in building and operating it. |
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Term
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Definition
nominal rate minus the expected rate of inflation.
This is the discount rate that should be used to calculate the NPV
If we expect inflation to be 5 percent per year on average, the real interest rate would be 9 − 5 = 4 percent. This is the discount rate that should be used to calculate the NPV of the investment in the electric motor factory. Note from Figure 15.3 that at this rate the NPV is clearly positive, so the investment should be undertaken. |
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Term
| Negative future cash flows create no problem for the NPV rule. |
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Definition
they are simply discounted, just like positive cash flows.
Suppose that our electric motor factory will take a year to build: $5 million is spent right away, and another $5 million is spent next year. Also, suppose the factory is expected to lose $1 million in its first year of operation and $0.5 million in its second year. Afterward, it will earn $0.96 million a year until year 20, when it will be scrapped for $1 million, as before. (All these cash flows are in real terms.) |
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Term
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Definition
Risk that can be eliminated either by investing in many projects or by holding the stocks of many companies.
Because investors can eliminate diversifiable risk, assets that have only diversifiable risk tend on average to earn a return close to the risk-free rate. if the project’s only risk is diversifiable, the opportunity cost is the risk-free rate. No risk premium should be added to the discount rate. |
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Term
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Definition
Risk that cannot be eliminated by investing in many projects or by holding the stocks of many companies.
For capital investments, nondiversifiable risk arises because a firm’s profits tend to depend on the overall economy. To the extent that a project has nondiversifiable risk, the opportunity cost of investing in that project is higher than the risk-free rate. Thus a risk premium must be included in the discount rate. |
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Term
| Capital Asset Pricing Model (CAPM) |
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Definition
Model in which the risk premium for a capital investment depends on the correlation of the investment’s return with the return on the entire stock market.
The expected return on the stock market is higher than the risk-free rate. Denoting the expected return on the stock market by rm and the risk-free rate by rf , the risk premium on the market is rm – rf. This is the additional expected return you get for bearing the nondiversifiable risk associated with the stock market. |
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Term
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Definition
A constant that measures the sensitivity of an asset’s return to market movements and, therefore, the asset’s nondiversifiable risk.
e.g. If a 1-percent rise in the market tends to result in a 2-percent rise in the asset price, the beta is 2. |
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Term
| The Risk-Adjusted Discount Rate |
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Definition
| Given beta, we can determine the correct discount rate to use in computing an asset’s net present value. That discount rate is the expected return on the asset or on another asset with the same risk. It is therefore the risk-free rate plus a risk premium to reflect nondiversifiable risk: |
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Term
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Definition
Weighted average of the expected return
on a company’s stock and the interest rate that it pays for debt. |
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Term
| The decision to buy a durable good... |
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Definition
| involves comparing a flow of future benefits with the current purchase cost |
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Term
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Definition
| Knowledge, skills, and experience that make an individual more productive and thereby able to earn a higher income over a lifetime. |
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Term
| Production decisions often have intertemporal aspects -- |
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Definition
production today affects sales or costs in the future.
Intertemporal production decisions involve comparisons between costs and benefits |
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Term
| Oil example: How fast must the price rise for you to keep the oil in the ground? Your production decision rule is: |
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Definition
| Keep all your oil if you expect its price less its extraction cost to rise faster than the rate of interest. Extract and sell all of it if you expect price less cost to rise at less than the rate of interest. |
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Term
| Price of an exhaustible resource |
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Definition
Price less marginal cost must rise at exactly the rate of interest.
-- In a competitive market, price less marginal production cost will rise at the rate of interest. |
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Term
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Definition
Opportunity cost of producing and selling a unit today and so making it unavailable for production and sale in the future.
i.e. User cost is the difference between price and marginal production cost. It rises over time because as the resource remaining in the ground becomes scarcer, the opportunity cost of depleting another unit becomes higher. |
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