The current worth of a future sum of money or stream of cash flows, discounted at a specified rate of return. It is distinct from future value, which calculates the value of a present sum at a future date.
PV helps investors decide if a future payout is worth its cost today by adjusting for the opportunity cost of capital.
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Future Value (FV)
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The value of an asset or cash at a specified date in the future, assuming a certain rate of return. It contrasts with present value, which discounts future amounts to their current worth.
FV demonstrates the power of compounding, showing how initial investments grow over time.
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Annuity
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A series of equal payments or receipts occurring at regular intervals over a finite period. It differs from a perpetuity, which continues indefinitely.
Common examples include loan payments, lease payments, and regular retirement contributions.
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Perpetuity
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A stream of equal cash flows that occurs at regular intervals and continues indefinitely. Unlike an annuity, it has no defined end date.
The present value of a perpetuity is simply the cash flow divided by the discount rate, making it useful for valuing preferred stock dividends.
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Effective Annual Rate (EAR)
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The actual annual rate of return earned or paid on an investment or loan, considering the effect of compounding over a given period. It differs from the Annual Percentage Rate (APR) by accounting for compounding frequency.
EAR provides a true comparison of interest rates from different financial products, as it standardizes for varying compounding periods.
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Expected Return
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The average return on an investment predicted over a specified period, calculated as the weighted average of all possible returns under different scenarios. It is a forward-looking estimate, unlike historical return.
Investors use expected return to forecast potential gains, but it does not guarantee actual performance.
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Standard Deviation
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A statistical measure that quantifies the amount of dispersion or variation of a set of data points around their mean, commonly used to represent the total risk of an investment. It measures total risk, whereas beta measures only systematic risk.
A higher standard deviation indicates greater volatility and thus higher total risk for an investment.
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Beta
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A measure of a stock's volatility in relation to the overall market, representing its systematic (non-diversifiable) risk. A beta of 1 indicates the stock moves with the market, while a beta greater than 1 suggests higher volatility.
Beta is crucial in the CAPM for determining the required rate of return for an asset, as it quantifies risk that cannot be eliminated through diversification.
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Capital Asset Pricing Model (CAPM)
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A financial model that calculates the expected return on an asset based on its systematic risk, the risk-free rate, and the expected market risk premium. It assumes investors are rational and markets are efficient.
CAPM provides a theoretical framework for pricing risky assets and for determining the cost of equity for a firm.
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Diversification
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The strategy of investing in a variety of assets to reduce overall portfolio risk, primarily by combining assets whose returns are not perfectly positively correlated. It primarily reduces unsystematic (company-specific) risk.
'Don't put all your eggs in one basket' is the core principle of diversification, aiming to smooth out returns by spreading investments.
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Net Present Value (NPV)
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The difference between the present value of a project's future cash inflows and the present value of its initial investment and future cash outflows. A positive NPV indicates that a project is expected to add value to the firm.
NPV is considered the most reliable capital budgeting technique because it directly measures the increase in shareholder wealth.
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Internal Rate of Return (IRR)
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The discount rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero. It represents the project's expected rate of return.
While intuitive, IRR can sometimes lead to incorrect decisions for mutually exclusive projects or projects with non-conventional cash flows.
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Payback Period
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The length of time required for an investment to generate enough cash flows to recover its initial cost. It is a simple measure of liquidity but ignores cash flows beyond the payback period and the time value of money.
Companies use the payback period for quick risk assessment, preferring projects that return their initial investment faster.
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Profitability Index (PI)
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The ratio of the present value of future cash inflows to the initial investment, indicating the present value of benefits per unit of cost. A PI greater than 1 suggests an acceptable project.
PI is useful for ranking independent projects when capital is rationed, as it shows which projects offer the most value per dollar invested.
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Mutually Exclusive Projects
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A set of projects where selecting one project automatically precludes the acceptance of any other project in the group. Firms must choose only one from the available options.
For mutually exclusive projects, the project with the highest positive NPV should always be chosen, even if another has a higher IRR.
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Incremental Cash Flows
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The additional cash flows, both inflows and outflows, that a firm expects to generate as a direct result of undertaking a specific project. They include all relevant cash flows, such as opportunity costs and externalities, but exclude sunk costs.
Only incremental cash flows should be considered in capital budgeting decisions to accurately assess a project's true financial impact.
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Sunk Cost
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A cost that has already been incurred and cannot be recovered, regardless of any future actions or decisions. It should be ignored in capital budgeting decisions because it is not an incremental cash flow.
'Don't cry over spilled milk' applies to sunk costs; focusing on them leads to irrational decisions based on past expenses rather than future profitability.
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Weighted Average Cost of Capital (WACC)
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The average rate of return a company expects to pay to all its security holders, weighted by the proportion of each component (debt, equity, preferred stock) in its capital structure. It represents the firm's overall cost of financing its assets.
WACC is commonly used as the discount rate for evaluating new projects with similar risk to the firm's existing operations.
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Cost of Equity
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The rate of return required by the firm's equity investors, reflecting the riskiness of the company's equity. It can be estimated using models like the CAPM or the Dividend Growth Model.
A higher cost of equity implies that investors demand a greater return for bearing the equity-specific risks of the company.
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Cost of Debt
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The effective interest rate a company pays on its borrowings, typically calculated on an after-tax basis due to the tax-deductibility of interest expenses. It is usually lower than the cost of equity because debt holders have a senior claim and interest is tax-deductible.
The after-tax cost of debt is used in WACC calculations to reflect the actual cost to the company.
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Financial Leverage
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The extent to which a firm uses debt financing in its capital structure, magnifying the impact of changes in operating income on earnings per share. Higher financial leverage increases the risk to equity holders but can also increase their returns.
While debt can boost returns to shareholders, excessive financial leverage can lead to financial distress and bankruptcy.
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Optimal Capital Structure
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The mix of debt and equity financing that minimizes a firm's weighted average cost of capital (WACC) and maximizes its market value. It is a theoretical target that balances the benefits of debt with its associated costs.
Finding the optimal capital structure involves a trade-off between the tax benefits of debt and the increased probability of financial distress.
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Trade-off Theory of Capital Structure
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A theory proposing that a firm's capital structure involves a trade-off between the tax benefits of debt and the costs of financial distress (e.g., bankruptcy costs, agency costs). Firms choose a capital structure where the marginal benefit of debt equals its marginal cost.
This theory explains why firms do not solely rely on debt, despite its tax advantages, due to the increasing risk of financial distress.
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Modigliani-Miller (MM) Theorem (without taxes)
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A foundational theory in corporate finance stating that under certain ideal assumptions (no taxes, no transaction costs, no bankruptcy costs, symmetric information), the value of a firm is unaffected by how it is financed (its capital structure).
The MM theorem provides a baseline understanding that capital structure only matters in the presence of market imperfections like taxes or financial distress costs.
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Dividend Payout Ratio
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The percentage of earnings paid out to shareholders in the form of dividends. It is calculated as total dividends divided by net income.
A high payout ratio indicates that a company is returning a large portion of its earnings to shareholders, while a low ratio suggests reinvestment for growth.
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Stock Split
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An increase in the number of a company's outstanding shares without altering the total market value of the company, typically done to reduce the per-share price and improve liquidity. It differs from a stock dividend, which involves issuing new shares as a percentage of existing shares.
A stock split makes shares more accessible to a wider range of investors, often perceived as a sign of management's confidence in future growth.
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Stock Dividend
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A dividend paid to shareholders in the form of additional shares of the company's stock, rather than cash. It differs from a stock split, which typically involves a larger proportional increase in shares and a lower per-share price.
Stock dividends conserve cash for the company while still rewarding shareholders, but they do not increase shareholder wealth in a perfect market.
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Net Working Capital (NWC)
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The difference between a company's current assets and its current liabilities, indicating the liquidity available to cover short-term obligations. Positive NWC implies a company has more readily convertible assets than short-term debts.
NWC is a key indicator of a company's short-term financial health and operational efficiency.
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Cash Conversion Cycle (CCC)
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The length of time, in days, it takes for a company to convert its investments in inventory and accounts receivable into cash, after accounting for the time it takes to pay its accounts payable. A shorter CCC is generally more desirable.
CCC measures how efficiently a company manages its working capital to generate cash, impacting its liquidity and profitability.
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Operating Cycle
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The average number of days required to convert raw materials into finished goods and then sell those goods to customers. It measures the time from the acquisition of inventory to the collection of cash from sales, excluding the time to pay suppliers.
The operating cycle helps management understand the duration of its core business activities, from production to sales.