Finance Flashcards

What is the purpose of working capital management?

Answer: To manage the company's short-term assets and liabilities to ensure sufficient liquidity for operations while minimizing the cost of maintaining working capital

Working capital management involves managing current assets (cash, receivables, inventory) and current liabilities (payables, short-term debt) to maintain the liquidity needed for daily operations while optimizing the trade-off between liquidity and profitability.

What is the yield to maturity (YTM) of a bond?

Answer: The total return anticipated on a bond if held until maturity, accounting for coupon payments, face value, current price, and time to maturity

YTM is the internal rate of return of a bond, assuming it is held to maturity and all coupon and principal payments are made as scheduled. It accounts for the current price, par value, coupon rate, and time to maturity, making it the most comprehensive measure of bond return.

In corporate finance, what is the agency cost of debt?

Answer: The costs arising from conflicts between debt holders and equity holders, such as the incentive for shareholders to take excessive risks or underinvest

Agency costs of debt arise because shareholders (through management) may act against the interests of debt holders. This includes asset substitution (taking riskier projects), underinvestment (forgoing positive NPV projects that mainly benefit creditors), and claim dilution (issuing more senior debt).

What is the Miller-Orr model used for in cash management?

Answer: Setting upper and lower control limits for cash balances, with a return point, to determine when to invest excess cash or sell investments to replenish cash

The Miller-Orr model sets upper and lower bounds and a return point for daily cash balances. When the cash balance hits the upper limit, the firm invests the excess. When it hits the lower limit, the firm sells investments. This optimizes the trade-off between holding costs and transaction costs.

What is a convertible bond and why might a company issue one?

Answer: A bond that can be converted to common shares at the holder's option; companies issue them to offer a lower coupon rate than straight debt and potentially issue equity at a premium above current share price

A convertible bond gives the holder the right to convert the bond into a predetermined number of common shares. Companies benefit from lower interest costs (the conversion feature has value) and potential equity issuance at an effective price above the current stock price.

What is the efficient frontier in portfolio theory?

Answer: The set of optimal portfolios that offer the highest expected return for a given level of risk, or the lowest risk for a given level of expected return

The efficient frontier, derived from Markowitz portfolio theory, represents the set of portfolios that are mean-variance optimal. Portfolios on the frontier cannot be improved — you cannot increase return without increasing risk or decrease risk without decreasing return.