Finance Flashcards

What are the advantages and disadvantages of using the IRR method versus the NPV method?

Answer: IRR is intuitive and provides a percentage return for comparison, but can give multiple solutions for non-conventional cash flows and may rank mutually exclusive projects incorrectly; NPV is theoretically superior

While IRR is intuitive (expressed as a percentage), it has limitations: multiple IRRs for non-conventional cash flows, potential conflicting rankings of mutually exclusive projects (due to scale and timing differences), and the reinvestment rate assumption. NPV is theoretically superior as it directly measures value creation.

What is the concept of operating leverage?

Answer: The degree to which a firm uses fixed operating costs versus variable costs, amplifying the sensitivity of operating income to changes in sales

Operating leverage reflects the proportion of fixed costs in a firm's cost structure. Higher fixed costs mean that a given percentage change in sales produces a larger percentage change in operating income (EBIT). The degree of operating leverage (DOL) measures this sensitivity.

What is the primary purpose of a cash flow statement in financial analysis?

Answer: To show the sources and uses of cash during the period, classified into operating, investing, and financing activities

The cash flow statement provides information about cash receipts and payments during the period, organized into three categories: operating activities (core business), investing activities (capital assets, investments), and financing activities (debt, equity, dividends). It reveals the company's liquidity and cash management.

What is the Sharpe ratio used for?

Answer: Measuring the risk-adjusted return of an investment by comparing excess return (above the risk-free rate) to total risk (standard deviation)

The Sharpe ratio = (Rp - Rf)/σp, where Rp is the portfolio return, Rf is the risk-free rate, and σp is the portfolio's standard deviation. A higher Sharpe ratio indicates better risk-adjusted performance. It is widely used to compare investments with different risk levels.

What is the concept of real options in capital budgeting?

Answer: The application of option pricing theory to real investment decisions, recognizing that management has flexibility to alter projects (expand, abandon, delay) based on new information

Real options recognize that management flexibility (to expand, contract, delay, abandon, or switch projects) has value beyond the static NPV calculation. Options like the option to delay capture the value of waiting for uncertainty to resolve before committing resources.

What is a leveraged buyout (LBO)?

Answer: An acquisition of a company using a significant amount of borrowed money, with the target's assets and cash flows used as collateral and to service the debt

An LBO involves acquiring a company using predominantly debt financing (typically 60-90% of the purchase price), with the target's assets and future cash flows serving as collateral. The acquirer uses a small equity contribution and plans to repay debt from the target's operations.