Finance Flashcards

What is the primary purpose of financial leverage?

Answer: To amplify returns to equity holders by using debt financing, which increases both the potential upside and downside

Financial leverage uses debt to magnify returns to equity holders. When the return on assets exceeds the cost of debt, leverage increases ROE. However, it also amplifies losses when returns fall below the cost of debt, increasing the financial risk borne by equity holders.

What is the internal rate of return (IRR) of a project?

Answer: The discount rate that makes the net present value of the project's cash flows equal to zero

The IRR is the discount rate at which the present value of a project's expected cash inflows equals the present value of its cash outflows (NPV = 0). A project is acceptable if its IRR exceeds the required rate of return (hurdle rate or cost of capital).

In portfolio theory, what does diversification achieve?

Answer: It reduces unsystematic (company-specific) risk but cannot eliminate systematic (market) risk

Diversification reduces unsystematic risk (specific to individual companies) by combining assets whose returns are not perfectly correlated. However, systematic risk (market-wide factors like interest rates, recessions) cannot be diversified away and remains in any portfolio.

What is the dividend discount model (DDM) used for?

Answer: Estimating the intrinsic value of a stock based on the present value of expected future dividends

The DDM values a stock as the present value of all expected future dividends. The constant growth version (Gordon Growth Model) is: P = D₁/(r-g), where D₁ is the expected dividend, r is the required return, and g is the constant growth rate in dividends.

Under the pecking order theory of capital structure, what is the preferred order of financing?

Answer: Internal funds (retained earnings) first, then debt, then external equity as a last resort

The pecking order theory suggests that firms prefer internal financing first (least information asymmetry), then debt (moderate information asymmetry), and finally external equity (greatest information asymmetry and adverse selection). This minimizes the costs associated with information asymmetry.

What is the payback period method of capital budgeting, and what is its main limitation?

Answer: It measures the time to recover the initial investment; its main limitation is that it ignores the time value of money and cash flows after the payback period

The payback period measures how long it takes for a project's cash inflows to recover the initial investment. While simple and intuitive, it ignores the time value of money, ignores cash flows occurring after the payback period, and uses an arbitrary cutoff rather than a value-based criterion.