Financial Management and Capital Budgeting Flashcards

Interest rate risk in bond investing refers to:

Answer: The risk that bond prices will fall when market interest rates rise

Interest rate risk is the inverse relationship between bond prices and market interest rates — when rates rise, existing bond prices fall, causing potential capital losses.

Which of the following measures a company's ability to meet interest payments from operating earnings?

Answer: Interest coverage ratio (times interest earned)

The interest coverage ratio (EBIT divided by interest expense) measures how many times operating earnings can cover the company's interest obligations.

The Modigliani-Miller theorem (without taxes) proposes that a firm's value is:

Answer: Independent of its capital structure

The Modigliani-Miller theorem states that in a perfect market without taxes, capital structure is irrelevant — the total firm value is unaffected by how it is financed.

A zero-coupon bond differs from a regular bond because it:

Answer: Pays no periodic interest and is issued at a discount to face value

A zero-coupon bond makes no periodic interest payments; instead, it is issued at a deep discount and redeemed at face value at maturity, with the difference representing the investor's return.

Economic Value Added (EVA) is calculated as:

Answer: Net operating profit after tax minus a charge for the cost of capital employed

EVA equals NOPAT minus the dollar cost of capital (invested capital × WACC), measuring whether a company earns more than its true cost of capital.

Which of the following would increase a company's operating leverage?

Answer: Shifting from variable to fixed production costs

Higher operating leverage results from a greater proportion of fixed costs in the cost structure, amplifying the impact of revenue changes on operating income.