Finance Flashcards

What is the efficient market hypothesis (EMH) and what are its forms?

Answer: The hypothesis that security prices fully reflect available information; weak form (past prices), semi-strong form (all public information), strong form (all information including private)

EMH states that security prices reflect available information. Weak form: prices reflect past trading data. Semi-strong form: prices reflect all publicly available information. Strong form: prices reflect all information, including private/insider information. Each form has implications for whether investors can earn abnormal returns.

What is the purpose of a sensitivity analysis in capital budgeting?

Answer: To examine how changes in individual input variables (revenue, costs, discount rate) affect the project's NPV or IRR, identifying which variables have the greatest impact

Sensitivity analysis tests how the project's outcome (NPV or IRR) changes when one input variable is varied while others are held constant. This identifies the key value drivers and the variables that create the most risk, helping management focus attention and risk mitigation efforts.

What is the difference between systematic risk and unsystematic risk?

Answer: Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is specific to an individual company and can be eliminated through diversification

Systematic risk (market risk) arises from factors affecting the entire economy (interest rates, inflation, recessions) and cannot be diversified away. Unsystematic risk (specific risk) is unique to a particular company or industry and can be eliminated by holding a diversified portfolio.

In option pricing, what factors affect the value of a call option?

Answer: Stock price, exercise price, time to expiration, volatility, risk-free rate, and dividends

Call option value increases with higher stock price, lower exercise price, longer time to expiration, higher volatility, higher risk-free rate, and lower expected dividends. These six factors are the inputs to option pricing models like Black-Scholes.

What is the purpose of the DuPont analysis?

Answer: To decompose return on equity (ROE) into its component parts — profit margin, asset turnover, and equity multiplier — to identify drivers of performance

DuPont analysis breaks ROE into three components: net profit margin (profitability), total asset turnover (efficiency), and equity multiplier (leverage). This decomposition reveals whether ROE is driven by operational efficiency, effective asset use, or financial leverage.

What is the trade-off theory of capital structure?

Answer: Companies balance the tax benefits of debt against the costs of financial distress to find an optimal capital structure

The trade-off theory suggests that firms choose their capital structure by balancing the tax shield benefit of debt (interest is tax-deductible) against the increasing costs of financial distress (bankruptcy costs, agency costs) as leverage increases. The optimal structure maximizes firm value.