FIN 120 - Exam 1
Terms in this set (51)
What are the three main questions in corporate finance? Explain what each of the three main questions means.
1. Capital Budgeting: What productive assets should the firm invest in? Benefits that outweigh costs
2. Financing: How will the firm pay for the investment? Paying Capital Budgeting
3. Working Capital Management: How will the firm manage the day-to-day financial matters? The short term expenses
What is debt-financing?
Borrowing to pay for investments
What is equity-financing?
Issuing stock to pay for
Define the term capital structure.
The mix of debt and equity
What is the role of the financial manager?
to make decisions that will
maximize the price of a firm's stock.
Define the term shareholder.
Any person, company or other
institution that owns at least one share of a company's stock.
Define the term stakeholder.
Anyone other than an owner
(shareholder) with a claim on the cash flows of a firm. Managers,
employees, suppliers, creditors, and the government
Define residual cash flow.
The cash remaining after a firm has paid operating expenses, creditors and taxes.
What is an agency relationship?
is created when the owner
(a principal) of a business hires an employee (an agent)
What is an agency cost?
Costs that arise from incurring and preventing conflicts of interest
between a firm's owners and its managers
What is the primary function of a
The primary function of a financial system is to efficiently transfer funds from lender-savers to
What is direct financing?
Directly through financial markets
What is indirect financing?
What is a primary market?
A wholesale market where firms' new securities are issued and sold for the first time
What is a secondary market?
Retail market where previously
issued securities are resold (traded)
What is marketability?
ease with which a seller or buyer for an asset can be found
What is liquidity?
ease with which an asset can be converted into cash without loss of value
What is a money market?
market for low-risk securities with maturities of less than one year.
Treasury Bills (T-Bills) & Commercial Paper
What is the capital market?
the market for securities with
maturities longer than one year. Bonds & Common Stock
Explain the efficient market
Fundamental Value = Market Value
• Current prices of securities incorporate the knowledge and expectations of all participants
• Security prices are correct; securities are not
over-valued or under-valued
• Implies: Price is what market says it is worth
Define interest rate.
is the fee for borrowing money
expressed as a percentage of a loan
What is the real rate of interest?
The interest rate that would exist in the absence of inflation/deflation
What is the nominal rate of
The interest rate adjusts for
What is inflation?
the rate at which the general level of prices for goods and services is rising.
What is the Fisher equation? How do you use it?
i = r + ∆ Pe
EX: If the real rate is 4% and the expected inflation rate is 10%, what is the approximate expected nominal rate?
i = r + ∆Pe
i = 0.04+ 0.10
i = 0.14 or 14%
Define the term book value.
The value of an asset or liability at the time it was acquired
Define the term market value.
The current price in the
What is the balance sheet?
A snapshot of the financial position at a single point in time. It includes three main items: assets, liabilities, and owner-supplied capital
What is the balance sheet
Total Assets = Total Liabilities + Shareholders Equity
Define the term
Net Working Capital.
Measure of a firm's ability to meet short term obligations as they come due.
What does a positive/negative net working capital indicate?
Positive: indicator firm has enough short-term assets to cover its short-term debt.
Negative: indicator firm may have trouble
paying for short-term liabilities.
What is the equation for
Net Working Capital?
Net Working Capital =
Current Assets - Current Liabilities
The cost of a physical asset such as plant or machinery is written off over its lifetime.
What is EBITDA? (Earnings-before-interest-taxes-depreciation-and-amortization)
Income from selling goods and services minus the cost of providing them
What is EBIT?
EBITDA minus depreciation and amortization
What is EBT? (Earnings-before-taxes)
EBIT minus interest expense and its Taxable income
What is NI? (Net income)
EBT minus taxes
What are retained earnings?
Shows cumulative effect of
adjustments to shareholders' equity resulting from profit, losses, and
What is the statement of cash flows?
Cash flows result from operating activities, investing activities, and
What is the equation for cash flows available to investors
from operating activities (CFOA)?
CFOA = EBIT - Current Taxes +
What is a common-size financial statement?
show the dollar amount of each item as a percentage of a reference value.
Define financial ratio.
a number from a financial
statement that has been scaled by dividing by another financial
What do liquidity ratios indicate?
indicate a firm's ability to pay
short-term obligations with
short-term assets without
endangering the firm. In general, higher ratios are a favorable indicator
What do profitability ratios
indicate whether a firm is
generating adequate profit from its assets.
In general, higher ratios indicate
What do leverage ratios indicate?
indicate whether a firm is using the appropriate amount of debt
financing. In general, higher ratios
indicate greater potential bankruptcy risk.
What do market value ratios
indicate how the market is valuing the firm's equity. Higher ratios
indicate greater shareholder wealth.
What is the dupont system?
Diagnostic tool for evaluating a firm's financial health
What are the three areas where the firm should focus efforts to
1. Operating Efficiency -measured by Net Profit Margin
2. Asset use Efficiency -measured by Total Asset Turnover
3. Financial Leverage -measured by Equity Multiplier
What is the dupont equation?
ROE = Net Profit Margin x Total Asset Turnover x Equity Multiplier
DuPont analysis involves breaking return-on-assets ratios into their
profit margin and turnover components.
Common-size analysis is used in financial analysis to:
compare companies of different sizes or compare a company with itself over time.
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