Financial Management Flashcards
How is a firm’s cost of capital determined?
Cost of capital is the rate of return that must be earned by prospective investors in order for a firm to attract and retain their investments.
Investors’ expected rate of return is determined primarily by the rate of return that could be earned on other opportunities with comparable risk; in other words, it is investors’ opportunity cost.
Define exit price.
The price that would be received to sell an asset or be paid to transfer a liability in an orderly transaction between market participants as of the measurement date. (this is fair value as defined by GAAP)
Identify and define the 3 approaches to determining fair value.
Market Approach: Information generated by market transactions for identical or similar items.
Income Approach: Converts future amounts of benefit or sacrifice to determine current value.
Cost Approach: Determines the amount required to acquire or construct a comparable item.
CAPM Formula
RR=RFR + B(ERR-RFR)
Determines the relationship between risk and expected return (gives the required rate of return) and uses that measure to assign value to securities, capital projects, etc.
Define Beta
Beta is a measure of the systematic risk associated with an investment as reflected by its volatility as compared with the volatility of the entire class of the investment.
Define business forecasting and how it is used.
Business forecasting is the estimation of the value of a variable at some future point in time. Its uses: budgeting process (ex. sales); Macro-economics (market growth, inflation rate); Demand (for production planning); Investment decisions (interest rates, etc.).
2 methods of business forecasting.
Qualitative (executive opinion, market research, and delphi method) and Quantitative (time series model and causal model).
What is the delphi method
Qualitative method of forecasting. It is a consensus developed by a group of experts using a multi-stage process to converge on a forecast.
Define Capital budgeting
The Process of measuring, evaluating, and selecting long-term investment opportunities, primarily in the form of projects or programs.
Define risk
The possibility of loss or other unfavorable results that derives from the uncertainty implicit in future outcomes.
Define risk premium
The rate of return expected above the risk-free rate based on the perceived level of risk inherent in an investment
Define risk free rate of return
The rate of return expected assuming virtually no risk. Rate of return expected solely for the Deferred current consumption that results from making an investment.
Describe the payback period approach to project evaluation
It determines the number of years needed to recover the initial cash investment in the project and compares the resulting time with a pre-established maximum payback period. It uses undiscounted expected future cash inflows.
Accounting rate of return formula
Average annual net income ( revenues minus expenses) / initial or average investment
Net Present Value formula
Present value of inflows - present value of outflows. If greater than 0 accept the project if not reject the project. Uses the discount rate / hurdle rate / weighted average cost of capital
