Principles of Corporate Finance – by F. Allen, R. A. Brealey, & S. Myers
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It is generally believed that an investment portfolio is better constructed the higher its Sharpe ratio (Sharpe Ratio – William F. Sharpe). The Sharpe ratio describes the relationship between a portfolio’s risk premium and its risk: Sharpe Ratio = Risk Premium/Standard DeviationSharpe Ratio = (Return-Risk Free Rate) / δ Why is this interesting? In the…
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The Black-Scholes-Merton (BSM) formula holds the same weight in financial science as E = mc² does in physics. The formula revolutionized the development of the options market. Thanks to it, the authors received the Nobel Prize, and savvy investors earned substantial profits. Substantively, the BSM is a transformation of the binomial method from a discrete…
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Does it matter if you purchase an Income stock or a Growth stock? Does a company’s decision to distribute dividends or reinvest earnings impact the stock price? The price of a stock, like any other asset, is derived from the expected future cash flows it will generate. These cash flows are essentially divided into two…
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Do You Use IRR to Evaluate Projects? Consider This: Many financial professionals use the Internal Rate of Return (IRR) for project evaluation, but it can be highly misleading. Despite its ease of use, there are significant drawbacks to relying solely on IRR. The main issue with IRR is that it assumes reinvestment of positive cash…
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Should an Organization Diversify into Different Business Areas? This question is crucial because one of the fundamental principles in financial theory is the principle of value additivity, which implies that 1+1=2. [ PV(a) + PV(b) = PV(ab) ] However, diversification clearly creates value. How do these two theories align? The issue is that in developed…
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How Does Diversification Reduce Risk? In finance, risk refers to the range of deviation from the forecasted or expected returns. This range is often based on historical statistics and is expressed in terms of standard deviation. An investor’s goal is to maximize returns while minimizing volatility. In other words, their aim is to maximize the…
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In the previous entry, I discussed how diversification can reduce an organization’s specific risks and mentioned that diversification cannot influence overall systemic, or market, risks. Imagine we have a highly diversified portfolio. Despite this, the portfolio cannot be entirely risk-free as its returns will still fluctuate based on the overall macroeconomic environment. This range of…