Finance Flashcards

What does the weighted average cost of capital (WACC) represent for a company?

Answer: The blended cost of all sources of capital (debt and equity), weighted by their proportion in the company's target capital structure

WACC represents the minimum rate of return a company must earn on its existing assets to satisfy its creditors, owners, and other providers of capital. It is calculated by weighting the after-tax cost of each source of financing by its proportion in the capital structure.

According to the Capital Asset Pricing Model (CAPM), what determines the expected return on a security?

Answer: The risk-free rate plus a premium for the security's systematic risk (beta multiplied by the market risk premium)

CAPM states that E(R) = Rf + β(Rm - Rf), where the expected return equals the risk-free rate plus a risk premium. Beta measures the security's systematic (non-diversifiable) risk relative to the market. Unsystematic risk is not rewarded because it can be diversified away.

What is the net present value (NPV) rule for capital budgeting decisions?

Answer: Accept projects with a positive NPV, as they are expected to add value to the firm

The NPV rule states that a project should be accepted if its NPV is positive, meaning the present value of expected future cash flows exceeds the initial investment. A positive NPV indicates the project earns more than the required rate of return and increases shareholder wealth.

What is the relationship between bond prices and interest rates?

Answer: Bond prices and interest rates have an inverse relationship: when interest rates rise, bond prices fall, and vice versa

Bond prices and interest rates have an inverse relationship because when market interest rates rise, existing bonds with lower coupon rates become less attractive, so their prices fall to offer comparable yields. Conversely, when rates fall, existing bonds become more valuable.

In working capital management, what is the cash conversion cycle?

Answer: Days inventory outstanding plus days sales outstanding minus days payables outstanding

The cash conversion cycle (CCC) measures the time between cash outflow for materials and cash inflow from sales: CCC = DIO + DSO - DPO. A shorter cycle means the company converts its investments in inventory and other resources into cash flows from sales more quickly.

What does the Modigliani-Miller theorem (without taxes) state about capital structure?

Answer: In a perfect market, the value of a firm is independent of its capital structure

The M&M theorem (Proposition I, no taxes) states that in a perfect capital market (no taxes, no bankruptcy costs, no agency costs, symmetric information), the value of a firm is unaffected by how it is financed. The overall cost of capital remains constant regardless of the debt-equity mix.