Finance Flashcards

What is the concept of the time value of money?

Answer: A dollar today is worth more than a dollar in the future because of its potential earning capacity, risk, and inflation

The time value of money recognizes that money available today can be invested to earn returns, making it more valuable than the same amount received in the future. This principle underlies discounting, compounding, and all of modern finance.

What is a company's beta in the context of the Capital Asset Pricing Model?

Answer: A measure of the company's systematic risk relative to the market, indicating how sensitive its returns are to market movements

Beta measures a security's systematic risk relative to the overall market. A beta of 1 means the security moves with the market. Beta > 1 indicates greater sensitivity to market movements (more volatile), while beta < 1 indicates less sensitivity.

What is the purpose of a interest rate swap?

Answer: To exchange fixed-rate interest payments for floating-rate interest payments (or vice versa) between two parties to manage interest rate risk

An interest rate swap allows two parties to exchange interest payment obligations — typically fixed for floating rate — on a notional principal amount. This helps manage interest rate exposure, reduce borrowing costs, or match assets and liabilities.

In valuation, what is the enterprise value (EV) of a company?

Answer: The total value of the firm, calculated as market capitalization plus total debt minus cash and cash equivalents

Enterprise value represents the theoretical total cost of acquiring a company. It equals the market value of equity plus debt plus minority interest plus preferred equity minus cash. EV is used in valuation multiples (EV/EBITDA) and represents the value to all capital providers.

What is the profitability index (PI) and how is it used in capital budgeting?

Answer: The present value of future cash flows divided by the initial investment; projects with PI greater than 1 should be accepted

The profitability index (benefit-cost ratio) is calculated as PV of future cash flows divided by the initial investment. A PI > 1 indicates the project creates value (same decision as NPV > 0). PI is particularly useful for ranking projects when capital is rationed.

What is the Gordon Growth Model and what are its limitations?

Answer: A model that values a stock as D₁/(r-g), assuming constant dividend growth in perpetuity; limited by the assumption of constant growth and requirement that growth rate must be less than the discount rate

The Gordon Growth Model values a stock at P = D₁/(r-g), where D₁ is next year's dividend, r is the required return, and g is the constant growth rate. Limitations include: assumes constant perpetual growth, g must be less than r, only applies to dividend-paying stocks, and is sensitive to input changes.