Corporate Finance
86 flashcards by MentisLibrary
Time value of money, NPV and IRR, WACC and CAPM, capital structure, valuation, and dividend policy. Formula on one side, the intuition for why it works on the other.
- What is the time value of money?
- A dollar today is worth more than a dollar later, because today's dollar can be invested and earn a return.
- What is future value?
- What a sum today will grow to after earning a return for a number of periods.
- What is present value?
- Today's worth of a future cash flow, found by discounting it at an appropriate rate.
- What is a discount rate?
- The rate used to convert future cash flows into present value, reflecting both the time value of money and risk.
- How does compounding frequency affect returns?
- More frequent compounding produces a higher effective return for the same stated annual rate.
- Nominal versus effective annual rate
- The nominal rate is the stated annual rate ignoring compounding; the effective rate reflects compounding within the year.
- What is an ordinary annuity?
- A stream of equal payments made at the end of each period for a fixed number of periods.
- What is an annuity due?
- An annuity whose payments occur at the beginning of each period rather than the end.
- What is a perpetuity?
- A stream of equal payments continuing forever.
- What is a growing perpetuity?
- A perpetual stream whose payments grow at a constant rate, valid only when the growth rate is below the discount rate.
- What is net present value?
- The present value of all a project's cash flows minus its initial cost.
- What is the NPV decision rule?
- Accept any project with a positive NPV; when choosing between mutually exclusive projects, take the highest NPV.
- What is internal rate of return?
- The discount rate at which a project's NPV equals zero, interpreted as the project's own compound return.
- What are the limitations of IRR?
- It can produce multiple values when cash flows change sign more than once, it assumes reinvestment at the IRR, and it can rank mutually exclusive projects wrongly.
- What is modified internal rate of return?
- A version of IRR that assumes cash flows are reinvested at the cost of capital rather than at the IRR.
- What is the payback period?
- The time required for cumulative cash inflows to recover the initial investment.
- What is discounted payback?
- The payback period computed on discounted cash flows rather than nominal ones.
- What is the profitability index?
- The present value of future cash flows divided by the initial investment.
- What is capital budgeting?
- The process of evaluating and selecting long-term investments.
- Which cash flows are relevant in capital budgeting?
- Incremental after-tax cash flows: those that change because of the project.
- How is depreciation handled in project cash flows?
- It is not a cash flow itself, but it reduces taxable income, creating a cash tax saving.
- What is net working capital investment in a project?
- The cash tied up in additional receivables and inventory less additional payables as a project ramps up.
- What is the cost of capital?
- The return investors require for supplying the funds a company uses, and therefore the minimum return its investments must earn.
- What is WACC?
- The weighted average cost of capital: the blended after-tax required return across a company's debt and equity.
- Why is the cost of debt multiplied by (1 minus the tax rate)?
- Interest is tax deductible, so each dollar of interest costs the company less than a dollar after tax.
- When is WACC the right discount rate?
- When the project has roughly the same risk and capital structure as the firm's existing business.
- What is CAPM?
- The capital asset pricing model, which prices the required return on equity as the risk-free rate plus beta times the market risk premium.
- What is beta in corporate finance?
- A measure of how sensitive an asset's returns are to overall market returns.
- Systematic versus unsystematic risk
- Systematic risk affects the whole market and cannot be diversified away; unsystematic risk is firm-specific and can.
- What is the market risk premium?
- The extra return investors demand for holding the market portfolio over the risk-free rate.