Investment & Capital Management Flashcards

What is capital budgeting?

Answer: Evaluating long-term investments

Capital budgeting is the process of evaluating potential large expenditures or investments that have long-term implications for a business. It involves analyzing projects such as purchasing new equipment, expanding facilities, or developing new products. The goal is to decide which projects will yield the most value and enhance shareholder wealth over an extended period.

What is the cost of capital?

Answer: Required investment return

The cost of capital represents the minimum rate of return that a company must earn on an investment project to maintain its market value and satisfy its investors. It is essentially the weighted average cost of all sources of financing, including debt and equity. This metric is fundamental for capital budgeting decisions, as projects must generate returns exceeding the cost of capital to be considered financially viable.

What is diversification in investment?

Answer: Spreading investments to reduce risk

Diversification in investment is a strategy that involves spreading investments across various assets, industries, and geographical regions. The primary goal is to reduce overall portfolio risk by ensuring that a poor performance in one investment does not severely impact the entire portfolio. By not putting all eggs in one basket, investors can mitigate specific risks and potentially achieve more stable returns.

What is the internal rate of return (IRR)?

Answer: Discount rate with NPV zero

The Internal Rate of Return (IRR) is a capital budgeting metric used to estimate the profitability of potential investments. It is defined as the discount rate at which the Net Present Value (NPV) of all cash flows from a project equals zero. Projects with an IRR higher than the company's cost of capital are generally considered acceptable, indicating a potentially profitable investment.

What is equity financing?

Answer: Selling company shares

Equity financing involves raising capital by selling ownership stakes in a company, typically in the form of shares, to investors. Unlike debt financing, it does not require repayment of borrowed money or interest payments. Instead, investors become shareholders and share in the company's profits and potential growth, aligning their interests with the company's success.

What is debt financing?

Answer: Borrowing money

Debt financing involves raising capital by borrowing money from lenders, such as banks or bondholders, with a promise to repay the principal amount along with interest. This creates a liability on the company's balance sheet and a fixed obligation to make payments. Unlike equity financing, lenders do not gain ownership in the company.

What is a capital asset?

Answer: Long-term business asset

A capital asset is a significant, long-term asset that a business uses to generate income over an extended period, typically more than one year. Examples include property, plant, and equipment (PP&E), such as buildings, machinery, and vehicles. These assets are not intended for sale in the ordinary course of business but rather for operational use and are recorded on the balance sheet.

What does the term 'liquidity' mean in finance?

Answer: Ease of converting assets to cash

Liquidity in finance refers to the ease and speed with which an asset can be converted into cash without significantly affecting its market price. Highly liquid assets, like cash or marketable securities, can be quickly turned into cash to meet financial obligations. Businesses need sufficient liquidity to manage their short-term liabilities and operational needs effectively.

Why is return on equity (ROE) important?

Answer: Measures profit from equity

Return on Equity (ROE) is a crucial financial profitability ratio that indicates how efficiently a company is using its shareholders' investments to generate profits. It measures the net income generated for each dollar of equity. A higher ROE generally signifies better financial performance and effective utilization of equity capital by the company.