50 Questions both Concepts and Problems Flashcards
What is the definition of Beta?
A measure of a stock’s volatility in relation to the overall market (also systematic risk)
Beta of 2,1,0.5 (Moves in the same direction as the Market)
Beta of -0.5, -1, -2 (Moves in the opposite direction of the market
Used to find Total Risk = Unsystematic Risk + Systematic Risk
Used in calculating the Required Return
Beta indicates the tendency of an investment’s returns to respond to swings in the market.
What are Bond Attributes?
Characteristics that define the nature of a bond, including maturity, coupon rate, face value, and Yield to Maturity
Coupon Rate: The annual interest paid to bondholders.
Maturity Date: When the principal is repaid.
Par Value (Face Value): The bond’s value at maturity.
Yield to Maturity (YTM): The total return if held to maturity.
Duration: Measures a bond’s sensitivity to interest rate changes.
Convexity: A more refined measure of interest rate risk.
Callable vs. Non-callable Bonds: Callable bonds can be repaid early, increasing risk for investors.
These attributes impact the bond’s risk and return profile.
What is Book Value?
The value of an asset according to its balance sheet account, representing the original cost minus depreciation.
The book value of an asset = Purchase Price - Accumulated Depreciation.
The book value of a company = Total Assets - Total Liabilities.
Example: A company has $500,000 in assets and $200,000 in liabilities. Its book value is $300,000.
Application: Investors compare book value with market value to assess over/undervaluation.
Book value can indicate a company’s net worth.
What does the Capital Asset Pricing Model (CAPM) describe?
A model that establishes a relationship between the expected return of an asset and its systematic risk.
Used to determine the expected return on an investment:
𝑟j=𝑟𝑓+𝛽(𝑟𝑚−𝑟𝑓)
Where:
rj = expected return
𝑟𝑓 = risk-free rate (e.g., Treasury bonds)
𝑟𝑚= market return
β = measure of systematic risk
Limitations: Assumes market efficiency, ignores real-world anomalies.
CAPM is used to estimate the expected return on an investment based on its risk.
What is Capital Budgeting? (List three key components of Capital Budgeting.)
The process of planning and managing a firm’s long-term investments.
Net Present Value (NPV):
𝑁𝑃𝑉=∑𝐶𝐹𝑡/(1+𝑟)^𝑡−InitialInvestment
Positive NPV → Accept the project
Negative NPV → Reject the project
Internal Rate of Return (IRR): The discount rate that makes NPV = 0.
Payback Period: Time to recover initial investment.
Profitability Index (PI): Measures value per dollar invested
- Estimating future cash flows
- Analyzing the risk of the investment
- Selecting the appropriate discount rate.
It involves evaluating potential major projects or investments.
What is Capital Structure?
The mix of a firm’s long-term debt and equity financing.
Debt Financing: Borrowing money (bonds, loans).
Equity Financing: Issuing stock.
Optimal Capital Structure: The mix of debt and equity that minimizes the cost of capital while maximizing firm value.
An important aspect of a company’s financial health, as it influences risk and the cost of capital.
NPV and IRR help decide whether an investment is profitable.
It determines the financial leverage of the company.
What is the Cost of Debt?
The effective rate that a company pays on its borrowed funds.
The total interest expense a company incurs on its borrowings, such as loans and bonds. It is an important metric that helps assess the financial health of a business and influences decisions regarding borrowing and investment.
It is a critical component in calculating a firm’s overall cost of capital.
Define Depreciation.
The allocation of the cost of a tangible asset over its useful life.
Depreciation affects both the value of the asset and the company’s tax liability.
What does Diversification refer to in finance?
The practice of spreading investments across various financial assets to reduce risk.
Reduces unsystematic risk (firm-specific risk).
A portfolio of 20-30 stocks in different industries is considered well-diversified.
It aims to minimize the impact of any single investment’s poor performance.
What is the purpose of a Dividend Policy?
To determine the amount and timing of cash distributions to shareholders.
Types: Regular, special, stock dividends.
Dividend payout ratio = DividendsperShare/EarningsperShare
Dividend policy can affect a company’s stock price and investor’s perceptions.
What are Efficient Markets?
Markets where asset prices reflect all available information at any time.
Weak-form efficiency: Prices reflect past market data.
Semi-strong efficiency: Prices reflect all publicly available info.
Strong efficiency: Prices reflect all info, including private data
Random Walk Hypothesis: Future stock prices are unpredictable.
Behavioral Finance: Challenges market efficiency (e.g., investor biases).
This concept is central to the Efficient Market Hypothesis.
What is Equity Capital?
Funds raised by a company in exchange for a share of ownership in the business. (Common or Preferred Stock)
It is used to finance operations and growth without the obligation to repay, unlike debt financing.
Funds raised by issuing stock (common or preferred).
Cost of equity (using CAPM):
𝑟𝑒=𝑟𝑓+𝛽(𝑟𝑚−𝑟𝑓)
Equity capital does not have to be repaid like debt capital.
What is an Ethics Program?
A framework for promoting ethical behavior within an organization.
Code of Conduct
Whistleblower Protections
Regulatory Compliance
It includes policies, training, and mechanisms for reporting unethical behavior.
What is the Financial Goal of a Firm?
To maximize shareholder value.
Maximizing shareholder wealth through strategic financial decisions.
Primary goal: Maximize shareholder wealth.
Metrics used: Earnings per Share (EPS), Return on Equity (ROE).
This involves making decisions that increase the market value of the firm’s equity.
What was the Glass-Steagall Act?
A law that separated commercial banking from investment banking to protect depositors and reduce the risk of financial speculation in the United States.
Enacted in 1933, separated commercial and investment banking.
Repealed in 1999, leading to more financial integration.
It aimed to reduce the risk of financial speculation.
What are Interest Rates?
The cost of borrowing money, expressed as a percentage of the principal.
Inflation (higher inflation → higher rates).
Monetary policy (set by central banks).
Risk (higher risk → higher required return).
Nominal vs. Real Interest Rates:
RealRate = NominalRate−InflationRate
Interest rates influence consumer spending, investment, and inflation.
What is the Internal Rate of Return (IRR)?
The discount rate that makes the net present value (NPV) of all cash flows from a project equal to zero.
Decision Rule: Accept the project if IRR > required return.
IRR is used to evaluate the profitability of potential investments.
What are the Legal Forms of a Business?
- Sole proprietorship (Unlimited Liability)
- Partnership (Shared Liability)
- Corporation (Limited Liability)
- Limited liability company (LLC).
What is Managerial Finance?
The branch of finance that deals with the management of a firm’s financial resources.
It focuses on financial decision-making and the strategic use of financial data.
What is the difference between Money and Capital Markets?
Money markets deal with short-term borrowing and lending (e.g., T-Bills, commercial paper), while capital markets are for long-term investments (e.g., stocks, bonds).
Money markets typically involve instruments with maturities of one year or less.
Define Preferred Stock.
A type of equity security that has preferential rights over common stock in terms of dividends and asset distribution. Have no voting rights and fixed dividends.
Formula for Price:
P=D/r
D: dividend, r: required return
Preferred stockholders typically receive fixed dividends.
What are Pro Forma Statements?
Financial statements that project future financial performance based on certain assumptions, such as mergers or new investments. Used for forecasting and decision-making.
They help businesses evaluate potential outcomes and make informed decisions, but they are not based on actual historical data and are not compliant with standard accounting principles.
They are often used for budgeting and forecasting.
What is the Required Rate of Return?
The minimum return an investor expects to receive for the risk taken.
It is used in capital budgeting to evaluate investment opportunities.
What is a Risk Premium?
The additional return expected for taking on additional risk. It compensates investors for taking on the extra risk associated with the investment.
It compensates investors for the uncertainty associated with an investment.
What does Risk vs Return refer to?
The relationship between the potential risk of an investment and the potential return it can generate.
Higher risk = High Returns, Lower Risk = Lower Returns
Relationship is typically known as a risk-return tradeoff, which helps investors make decisions based on risk tolerance and investment goals
Generally, higher risks are associated with higher potential returns.
What is the Role of an Accountant vs a Financial Analyst?
Accountants focus on recording and reporting financial transactions, while financial analysts evaluate financial data to guide investment decisions.
Accountant: Prepares financial statements, ensures compliance.
Financial Analyst: Evaluates investments, forecasts trends.
Both roles are essential for effective financial management.
What are Securities Exchanges?
Platforms where financial instruments, such as stocks and bonds, are bought and sold. It ensures transparency and liquidity in the market.
(New York Stock Exchange, NASDAQ)
They provide liquidity and transparency in the financial markets.
Who are Stakeholders in a Firm?
- Shareholders
- Employees
- Customers
- Suppliers
- Community members.
- Government
What is the difference between Systematic and Unsystematic Risk?
Systematic risk affects the entire market, while unsystematic risk is specific to a particular company or industry.
Systematic Risk: Market-wide, cannot be diversified away.
Unsystematic Risk: Company-specific, can be reduced through diversification.
Systematic risk cannot be diversified away.
What does Time Value of Money refer to?
The concept that money available now is worth more than the same amount in the future due to its potential earning capacity.
Future Value and Present Value
This principle underlies many financial calculations.
What is the Yield Curve?
A graphical representation of interest rates on debt for a range of maturities.
Normal curve: Long-term rates higher than short-term (Normal Economy)
Inverted curve: Short-term rates higher (recession indicator).
It reflects investor expectations about future interest rates and economic activity.
Problem: The Future Value of a Lump Sum
FV = PV(1+i)^N
Problem: Payback Period Equation
Initial Investment / Annual Cash Flow
It is a simple measure of investment liquidity.
Problem: P/E Ratio equation
=Stock Price / Earnings Per Share
It is used to assess if a stock is over or under-valued.
Problem: Perpetuity Equation
PV = C/r
Growth PV = C/(r-g)
PV: Present Value
C: The amount of cash paid each period
r: The interest rate or yield
g: growth Rate
The present value of a perpetuity can be calculated using a specific formula.
Problem: Present Value of a Lump Sum
PV = FV/(1+i)^N
This concept is crucial for investment and financial planning.
Problem: Taxes
Figure it out later
Taxes can significantly impact a firm’s profitability and cash flow.
