IFA Business Finance & Investment Flashcards

What is the difference between systematic and unsystematic risk?

Answer: Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is company-specific and can be diversified

Systematic (market) risk cannot be eliminated through diversification as it affects all securities, while unsystematic (specific) risk can be reduced by holding a diversified portfolio.

What does portfolio diversification achieve for an investor?

Answer: Reduces unsystematic risk by combining assets whose returns are not perfectly correlated

Diversification reduces unsystematic risk because when some assets perform poorly, others may perform well, smoothing overall portfolio returns.

What is a rights issue in corporate finance?

Answer: An offer of new shares to existing shareholders in proportion to their current holdings

A rights issue allows existing shareholders to purchase new shares at a discount, typically in proportion to their current holding, giving them the 'right' to maintain their ownership percentage.

What does the term 'cost of debt' refer to in capital structure analysis?

Answer: The effective after-tax interest rate the company pays on its borrowings

The cost of debt is the effective interest rate a company pays on its debt, typically calculated on an after-tax basis because interest payments are tax-deductible.

What is the capital asset pricing model (CAPM) used for?

Answer: Estimating the expected return on an investment based on its systematic risk (beta)

CAPM calculates the expected return of an asset as the risk-free rate plus a risk premium based on beta, which measures sensitivity to market movements.

Which capital budgeting technique accounts for the time value of money?

Answer: Net present value (NPV)

NPV discounts all future cash flows back to present value using a required rate of return, directly incorporating the time value of money into the investment decision.