Low coupon bonds are more volatile because the face value received at the maturity date as a lump sum is a big chunk of the total bond’s value. Interest payments along the way are not as significant. This means changes…
The difference between the Return on Invested Capital and the Return on Equity is that the ROIC measures how effective is the company’s employment of all sources of capital at increasing the operating income, while the ROE compares the capital…
A price to book below 1 indicates the stock is undervalued. It means the market values the company below its accounting net worth. This could be an investment opportunity, or a sign the business lacks future growth opportunities. Here’s a…
Here’s a table showing you the equivalent ratings between the big three credit rating agencies: S&P Moody’s Fitch AAA Aaa AAA AA+ Aa1 AA+ AA Aa2 AA AA- Aa3 AA- A+ A1 A+ A A2 A A- A3 A- BBB+…
To calculate the cost of equity using the CAPM, you need the beta of the company. The problem is that beta is a volatility measure based on the stock market. What if the company you’re evaluating isn’t publicly traded? The…
The fundamental difference between ROIC and ROA lies in the difference between invested capital and total assets. The Return on Invested Capital compares operating income to money shareholders and lenders have put into the company, which tells you its ability…
No. Invested capital is the sum of the book value of equity and the debt that pays interest to investors minus the non-operating assets. Total assets on the other hand, is the sum of total equity and total liabilities. Want…
Welcome. In this article, we’ll look at three examples of real options valuation in capital budgeting. You’ll learn how to compute the value of three different types of real options, no matter if they’re American or European-style options, using both…
The expanded net present value (ENPV) is the total value of a project, including the value of being able to adapt to new market conditions. It is equal to the NPV of the investment plus the value of real options.…
The most common way to forecast capital expenditures (CapEx) in a discounted cash flow (DCF) analysis is to get the historical average CapEx as a percentage of revenue and use that to calculate its future value as a function of…
The revenue multiple is better when you’re dealing with young companies that are not profitable yet, companies that are sensitive to market cycles, or that are in industries with an established profit margin. The EBITDA multiple is better to capture…
When the IRR (Internal Rate of Return) is greater than the WACC (Weighted Average Cost of Capital), it means the investment’s rate of return covers the costs of financing it. Therefore, the project should be accepted. For a deeper understanding…
The Constant Absolute Risk Aversion (CARA) utility function is a measure of risk aversion. It is characterized by a constant absolute risk aversion coefficient, meaning risk aversion is the same for all levels of wealth. This is unrealistic, as wealthy…
The opposite of risk aversion is risk-seeking behavior. Risk-seeking investors are willing to put up with higher risk for a higher chance of better returns. Risk averse investors on the other hand, prefer a lower risk investment such as government…
The sticky delta rule refers to the assumption that the implied volatility of options with a certain delta will stay the same as the underlying asset price fluctuates up or down. It is also called the volatility-by-moneyness rule, as options…
Asset transformation can be described as the process through which banks transform customers’ deposits into loans for borrowers. This is how banks make most of their money. It is the bread and butter of the banking business model. However, to…
Strict exogeneity is one of the assumptions supporting the Ordinary Least Squares (OLS) method in regression analysis. It states that the explanatory variables are not correlated with the error term of the model. This guarantees the estimated coefficients are unbiased,…
Multiple on Invested Capital (MOIC) is a return metric commonly used in private equity to track fund performance. It is calculated by dividing realized value and unrealized value by the amount invested. Still confused? Keep reading. We’ll start by diving…
No. Stock prices and dividend payments are not connected directly. However, if the dividend stays the same and the stock price goes down, the dividend yield goes up. This does not mean the company changed its dividend policy. That’s the…
A negative debt-to-equity ratio means the company is in financial distress. Why? Because it implies shareholders’ equity is negative as well, which means total liabilities exceed total assets. This is bad, as it indicates the company’s net worth is negative.…
Imperfect multicollinearity occurs when two or more explanatory variables in a statistical model are correlated with each other, but not perfectly. That’s the gist of it. To get a full explanation of imperfect multicollinearity, keep reading: #1) Imperfect Multicollinearity Definition…
The gross IRR tells you the rate of return you can expect from an investment, before taking into account the costs the investment fund charges you, as an investor, such as management and performance fees. The net IRR takes these…
The VIX Index calculation takes the variance of two sets of SPX options with expiration dates between 23 to 37 days in the future. Then, it interpolates the variance between both. Finally, it takes the square root of that and…
The difference between the VIX and the VXX is that the VXX is an ETN (exchange-traded note) that tracks the performance of a basket of VIX futures contracts. On the other hand, the VIX index is a theoretical construct that…
Yes, you can short the VIX. There are a couple of ways to do it, namely: You can short VIX futures, you can buy put options on these futures, or you can short VIX ETFs (or buy VIX inverse ETFs).…
Equity financing is more expensive than debt financing because as a shareholder you partake in more risk than a bondholder. Because of this, shareholders want to receive higher returns to compensate for the additional risk they take. Now, you may…
Time series data is data collected at regular intervals over time. On the other hand, cross-sectional data is a snapshot of a group of things or people at the same point in time. For example, a time series dataset of…
Capital budgeting decisions are generally based on a company’s long-term investment plans and objectives. Have you ever wondered how businesses decide which investments to make? The process of evaluating and choosing long-term investment options is called capital budgeting. In this…
The advantages of a stock split are: The disadvantages of a stock split: Wanna know more? In this post I explain stock split and its pros and cons: What is Stock Split A stock split happens when a company issues…
As an investor, student, or financial analyst, you may have come across the terms CAPM and WACC. If you think they are similar, you are mistaken, as they are quite different. However, despite having distinct applications in the world of…
Net Present Value (NPV) is negative when the present value of a project’s benefits is lower than the present value of its costs. Generally, a project is considered acceptable if its net present value is positive. Taking on a negative…
Put-call parity with continuous dividends is different from put-call parity without dividends. Dividends increase the value of the underlying asset. Thus, if you want to maintain put-call parity, you need to eliminate this effect by discounting the underlying asset’s price…
The optimal risky portfolio (also called tangency portfolio) is a portfolio composed of risky assets in which the amount you invest in each asset will make it so the portfolio gives you the highest possible return for a given level…
Both WACC and APV help you get the present value of a project or asset that will generate future cash flows. The difference between APV and WACC is that APV incorporates the value of the interest tax shield generated from…
If you’re calculating a firm’s free cash flow to figure out its valuation, you may be wondering why changes in working capital are a cash flow. An increase in net working capital means a cash outflow because it indicates the…
Earnings before interest, taxes, depreciation, and amortization (EBITDA), and revenue are key metrics of profitability and health of a business. Both indicate financial performance, but the main difference is that revenue tells you how much the company sells in total,…
Net working capital (NWC) is the difference between current assets and current liabilities in a company’s balance sheet. When the value of the current liabilities exceeds the value of the current assets, the company has a negative net working capital.…
When a company is in financial distress it hires outside professionals, such as tax and accounting experts with experience selling distressed assets. Investment bankers may also assist with financial restructuring. These are direct costs of financial distress. Aside from the…
Financing through debt is cheaper than through equity. This means more debt lowers the total cost of capital of a company, increasing its value. On top of that, increasing debt reduces the amount of corporate taxes a company has to…
In this post, you’ll learn what is CRRA utility function (also called power utility function). We’ll go over 6 things you must know to understand the CRRA formula and the CRRA utility function properties. CRRA stands for Constant Relative Risk…
An asset is nothing else than the right to future cash flows, whether they are interest payments from bonds, dividend payments from stocks, insurance payments, or capital gains from investments. To price an asset, all you need to do is…
Utility theory in finance measures how much benefit you, as an investor, get from a given asset, and how that will affect your decision to buy that asset over another. We know supply and demand determine the price of an…
This is a basic introduction to understanding the logic behind the one-step binomial model. We won’t be going deep on the algebra. This overview of the binomial option pricing model will help you understand the: Binomial trees widely used to…
Options are financial derivatives traded over 40 million times every day. Knowing that, you may be wondering… What’s all the fuss about? Calls? Puts? Strike price? In-the-money? OTM? Intrinsic value? Premium? What does all this jargon mean? In this article,…
Options are financial derivatives that allow you to hedge the risk of an existing position, or speculate on the price movements of a stock. There are many option strategies you can use to achieve different goals. In this post, we’ll…
Free cash flow (FCF) is the cash left over after a company pays the expenses that: Earnings are a company’s after-tax profits. Also known as the net income, or the bottom line. What’s the difference? Earnings vs. Cash Are earnings…
One of the main goals of science is to investigate the relationship between different things, so we can predict their future evolution and better understand our reality. The relationship between education level and income. Math exam results and hours studied.…
In this post, we’ll look at what happens to WACC as debt increases. We’ll start off by defining WACC, and understanding how it works. Then, we’ll describe the effect of financing strategies on the cost of capital. Financing strategies are…
A European Put Option gives you the right to sell a stock at a predetermined price at a future date. You must pay a certain price to have access to this right. What’s the maximum that price can reach, and…
This is an introduction to Statistical Inference, and its most useful tool—Hypothesis Testing. We’ll start off with an overview of the field of Statistics this tool belongs to, as well as the basic concepts we need in order to understand…