Definitions

Question 1

Compound interest

Answer 1

The situation in which interest paid on an investment
during the first period is added to the principal.
During the second period, interest is earned on
the original principal plus the interest earned
during the first period.

Question 2

Future value

Answer 2

The amount to which your investment will grow, or a future dollar amount

Question 3

Future value factor

Answer 3

The value of (1 + r)^n used as a multiple to calculate an

amount’s future value.

Question 4

Simple interest

Answer 4

If you only earned interest on your initial investment, it would be referred to as simple interest.

Question 5

Present value

Answer 5

The value in today’s dollars of a future payment discounted back to present at the required rate of return.

Question 6

Present value factor

Answer 6

The value of 1 / (1 + r)^n used as a multiplier to calculate an amount’s present value.

Question 7

Annuity

Answer 7

A series of equal dollar payments made for a specified number of years.

Question 8

Ordinary annuity

Answer 8

An annuity where the cash flows occur at the end of each period.

Question 9

Compound annuity

Answer 9

Depositing an equal sum of money at the end of each year for a certain number of years and allowing it to grow.

Question 10

Annuity future value factor

Answer 10

The value of [(1 + r)^n - 1 / r ] used as a multiplier to

calculate the future value of an annuity.

Question 11

Annuity present value factor

Answer 11

The value of [1 - (1 + r)^-n / r ] used as a multiplier

to calculate the present value of an annuity

Question 12

Annuity due

Answer 12

An annuity in which the payments occur at the beginning of each period.

Question 13

Amortized loan

Answer 13

A loan that is paid off in equal periodic payments.

Question 14

Effective annual rate (EAR)

Answer 14

The annual compound rate that produces the same
return as the nominal, or quoted, rate when something is compounded on a nonannual basis. In effect, the EAR provides the true rate of return.

Question 15

Perpetuity

Answer 15

An annuity with an infinite life.

Question 16

Incremental Cash Flow

Answer 16

The difference

between the cash flows a company will produce both with and without the investment it is thinking about making.

Question 17

Opportunity cost,

Answer 17

The cost of making

a choice in terms of the next best alternative that must be foregone.

Question 18

Efficient market

Answer 18

A market in which
the prices of securities at any instant in time fully reflect all publicly available information about the securities and their actual public values.

Question 19

Agency problem

Answer 19

Problems and conflicts resulting from the separation of the

management and ownership of the firm.

Question 20

Capital budgeting

Answer 20

The process of
decision making with respect to investments
made in fixed assets; that is, should a proposed project be accepted or rejected?

Question 21

Capital structure decision

Answer 21

The

decision-making process with funding choices and the mix of long-term sources of funds.

Question 22

Working capital management

Answer 22

The

management of the firm’s current assets and short-term financing.

Question 23

Financial markets

Answer 23

Those institutions
and procedures that facilitate transactions
in all types of financial claims.

Question 24

Sole proprietorship

Answer 24

A business owned by a single individual.

Question 25

Partnership

Answer 25

An association of two or more individuals joining together as co-owners to operate a business for profit.

Question 26

General partnership

Answer 26

A partnership in which all partners are fully liable for the indebtedness incurred by the partnership.

Question 27

Limited partnership

Answer 27

A partnership in which one or more of the partners has limited liability, restricted to the amount of capital he or she invests in the partnership.

Question 28

Corporation

Answer 28

An entity that legally

functions separate and apart from its owners.

Question 29

S-corporation

Answer 29

A corporation that,

because of specific qualifications, is taxed as though it were a partnership.

Question 30

Limited liability company (LLC)

Answer 30

A cross between a partnership and a corporation under which the owners retain
limited liability but the company is run and is
taxed like a partnership.

Question 31

Weighted average cost of capital

Answer 31

The discount rate that is used to calculate the firm’s value.

Question 32

Opportunity cost

Answer 32

The cost of making a choice defined in terms of the next best alternative that is foregone.

Question 33

Financial policy

Answer 33

The mix of sources of funds that the firm uses when raising new money to finance its investments.

Question 34

Cost of debt

Answer 34

The rate that has to be received from an investment in order to achieve the required rate of return for the creditors. This rate must be adjusted for the fact that an increase in interest payments will result in lower taxes. The cost is based on the debt holders’ opportunity cost of debt in the capital markets.

Question 35

Flotation costs

Answer 35

The costs incurred by the firm when it issues securities to raise funds.

Question 36

Cost of preferred equity

Answer 36

The rate of return that must be earned on the
preferred stockholders’ investment in order to satisfy their required rate of return. The cost is based on the preferred stockholders’ opportunity cost of preferred stock in the capital markets.

Question 37

Cost of common equity

Answer 37

The rate of return that must be earned on the common stockholders’ investment in order to satisfy their required rate of return. The cost is based on the common stockholders’ opportunity cost of common stock in the capital markets.

Question 38

capital structure

Answer 38

The mix of long-term sources of funds used by the firm. This is also called the firm’s capitalization. The rela
tive total (percentage) of each type of fund is emphasized.

Question 39

Divisional WACC

Answer 39

The cost of capital for a specific business unit or division.

Question 40

Financial ratios

Answer 40

accounting data restated in relative terms in order to help
people identify some of the financial strengths and weaknesses of a company.

Question 41

Liquidity

Answer 41

a firm’s ability to pay its bills on time. Liquidity is related to the ease and speed with which a firm can convert its noncash assets into cash, as well as to the size of the firm’s investment in noncash assets relative to its short-term liabilities.