Corporate Finance

Question 1

Corporate Finance

Answer 1

The study of how corporations raise and use capital, how corporate financial managers evaluate possible capital investments, and how corporations are governed by their shareholders.

Question 2

Corporation

Answer 2

A seperate, legal, tax-paying entity

Question 3

Board of directors

Answer 3

Elected by shareholders; responsible for hiring and monitoring the managers

Question 4

Corporate Governance

Answer 4

How corporations are organized to ensure that management acts in the owners’ interests.

Question 5

Initial Public Offering (IPO)

Answer 5

the process of offering shares of a private corporation to the public in a new stock issuance

Question 6

proprietorship

Answer 6

The least complicated form of business to establish.

Question 7

Partnership

Answer 7

A legal contract between two or more individuals that share the ownership interests in a business

Question 8

Unlimited Life

Answer 8

when a corporation continues to exist even after an owner dies, leaves the business, or transfers his or her ownership.

Question 9

Limited Liability

Answer 9

A business law principle that shields individual shareholders from liability for debts owed by a business entity to the extent of the shareholder’s investment in the entity.

Question 10

Ease of Ownership Transfer

Answer 10

The ease of transferability allowed the new owners to transfer the ownership of the shares without any hassle, and the former owners received the payment for their shares without any additional paperwork or legal formalities.

Question 11

Retained Earnings

Answer 11

the cumulative net earnings or profits of a company after accounting for dividend payments.

Question 12

business risk

Answer 12

any factor that could prevent a company from achieving its financial goals, such as lowering profits or leading to failure. Business risks can increase the chances of losses and reduce opportunities for profit.

Question 12

Financial Risk

Answer 12

Comes from the way management finances the firm’s assets and growth.

Question 13

Leverage

Answer 13

also known as gearing, is a technique that involves borrowing money to maximize returns on an investment or project. It can also be used to acquire assets or raise funds for a company.

Question 14

Risk

Answer 14

the possibility of a negative financial outcome or loss that could occur from an investment decision. This includes the chance that the actual gains from an investment will differ from what was expected. Risk can also refer to the possibility that a company’s cash flow will not be enough to meet its obligations, or that a government will default on its bonds.

Question 15

Return

Answer 15

the money made or lost on an investment over a period of time. It can also be defined as the total income an investor receives from their investment each year. Return is usually expressed as a percentage of the original value of the investment or as the change in dollar value over time.

Question 16

Uncertainty

Answer 16

A synonym for risk; the lack of cerainty or sureness of an event

Question 17

Macroeconomic Variables

Answer 17

economy-wide in nature and affect all stock prices to varying degrees. for instance, inflation causes overall prices increases, resulting in decrease in demand and reduced profits.

Question 18

Microeconomics Variables

Answer 18

Variables that are specific to each firm

Question 19

Business Risk

Answer 19

any factor that could prevent a company from achieving its financial goals or lower its profits.

Question 20

Revenue Variability

Answer 20

Measuring differences between actual sales and expected sales

Question 21

Cost and price structure

Answer 21

A pricing structure that refers to the specific way prices are set or organized within a business. It deals with how prices are arranged for different products or services and can include various models such as flat rate, tiered pricing, pay-per-use, bundle pricing, and psychological pricing

Question 22

Competition

Answer 22

the rivalry between companies selling similar products and services with the goal of achieving revenue, profit, and market share growth.

Question 23

operating leverage

Answer 23

used to calculate a company’s break-even point and help set appropriate selling prices to cover all costs and generate a profit. Operating leverage depends upon the proportion of the firm’s costs that are fixed. The higher the proportion of fixed costs, the less flexibility management has in lowering cost to accomodate weak sales.

Question 24

financial risk

Answer 24

the possibility of losing money when making financial decisions, such as investing in a business or other venture. It can also refer to the risk that a business won’t be able to repay its debts, which could result in investors losing their money. Financial risk is characterized by uncertainty in the outcomes of financial transactions or investments.

Question 25

financial leverage

Answer 25

the percentage change in net income resulting from a given percentage change in EBIT (earnings before interest and taxes)

Question 26

capital structures

Answer 26

the relative proportions of debt and equity the owners of a firm have used to finance its operations. We can observe a firm’s capital structure by examining its balance sheet.

Question 27

target capital structure

Answer 27

the debt ratio that the firm tries to maintain over time and is typically similar to the average for the industry in which the firm operates. Should the firm’s debt ratio fall below the target level, the firm will raise new capital by retaining earnings or issuing new equity.

Question 28

optimal capital structure

Answer 28

balances the influence of risk and return and maximizes the firm’s stock price. The optimal debt ratio will be the firm’s target capital structure.

Question 29

tax shield

Answer 29

the tax savings resulting from the tax-deductibility of the interest expense on debt borrowings. The payment of interest expense reduces the taxable income and the amount of taxes due – a demonstrated benefit of having debt and interest expense.

Question 30

financial flexibility

Answer 30

Refers to a firm’s ability to go to the capital markets and raise funds at reasonable terms. If the firm already employs a good deal of debt, management might find it difficult to sell new debt

Question 31

Capital Components

Answer 31

The right side of a firm’s balance sheet is debt, preferred stock and common equity, which are normally referred to as the capital components of the firm.

Question 32

Component Cost of Capital

Answer 32

Any increase in a firm’s total assets financed through an increase in at least one of the capital components. The cost of the components are called component costs of capital.

Question 33

Cost of debt

Answer 33

The interest rate at which the firm can issue new debt net of the tax savings resulting from the tax-deductibility of interest payments

Question 34

Cost of preferred stock

Answer 34

A perpetuity that pays a fixed dividend forever. The cost of preferred stock is the rate of return that preferred shareholders require to invest in a company’s preferred stock. It’s calculated by dividing the annual preferred dividend paid out (DPS) by the current market price. The formula for calculating the cost of preferred stock is:
Rp = D (dividend)/ P0 (price)
For example, if a company has preferred stock with an annual dividend of $3 and a current share price of $25, the cost of preferred stock is:
Rp = 3 / 25 = 12%
Preferred stock is a hybrid security that combines features of common stock and bonds. It’s considered less risky than common stock but more risky than bonds. Preferred shareholders have priority over a company’s income, meaning they are paid dividends before common shareholders and have priority in the event of a bankruptcy.

Question 35

The capital asset pricing model approachs (CAPM)

Answer 35

The capital asset pricing model (CAPM) describes the relationship between systematic risk, or the general perils of investing, and expected return for assets, particularly stocks. It is a finance model that establishes a linear relationship between the required return on an investment and risk.

E(R_{i}) = R_{f}+\beta_{i}(E(R_{m})-R_{f})
E(R_{i}) = capital asset expected return
R_{f} = risk-free rate of interest
\beta_i = sensitivity
E(R_{m}) = expected return of the market

Question 36

Cost of Common Equity

Answer 36

the return that a firm’s stockholders require on the equity that the firm retains from its earnings. If a stick is in equilibrium, the rate of return investors require is equal to the rate of return they expect to get.

Question 37

Discounted cash flow approach

Answer 37

a valuation method that estimates the value of an investment using its expected future cash flows.
It is the sum of the cash flow in each period divided by one plus the discount rate (WACC) raised to the power of the period number

\text{DCF} =\frac{CF_{1}}{(1+r)^{1}}+\frac{CF_{2}}{(1+r)^{2}}+\cdots+\frac{CF_{n}}{(1+r)^{n}}
\text{DCF} = discounted cash flow
CF_i = cash flow period i
r = interest rate
{n} = time in years before the future cash flow occurs