Foundational Concepts in Corporate Finance Flashcards

This set covers fundamental corporate finance terms from units 1 through 10, including role of finance, TVM tools, project evaluation, risk management, and financial strategy.

Finance (Functional Role)

The universal language of business executives and investors used to communicate initiatives, allocate capital, and quantify project effects in tractable terms.

Corporation

A form of business organisation where ownership (held by investors) and operational control (delegated to professional managers) are separated.

Capital Users

Entities, such as corporations, that discover real projects and require funding from the financial system.

Capital Providers

Institutional or individual investors, such as superannuation funds or brokerage account holders, who supply savings to the financial system.

Book Value

An objective and precise measure of an asset's value based on its original purchase price, which may be reduced over time through depreciation.

Market Value

The price at which an asset can be sold at any given moment, fluctuating based on investors' expectations of future profitability.

Corporate Governance

A branch of finance that studies how managers make decisions and the effects of those decisions on different stakeholders.

Time Value of Money (TVM)

The fundamental principle that a dollar today is worth more than a dollar tomorrow.

Compounding

The process of calculating the value of a current cash amount at a specific point in the future by applying an interest rate.

Discounting

The process of calculating the value today (Present Value) of a cash amount to be received in the future.

Annuity

An evenly spaced stream of identical cash flows, such as mortgage payments or periodic dividends.

Perpetuity

An annuity that lasts forever; its present value is calculated as $P = \frac{C}{r}$.

Growing Perpetuity

A perpetual stream of cash flows where each payment grows by a constant rate ($g$) each period; its present value is $P = \frac{C_{1}}{r - g}$.

Capital Budgeting

The process of evaluating investment projects to determine their value and deciding how to allocate capital among them.

Net Present Value (NPV)

The primary investment metric in corporate finance, calculated as the difference between the present value of cash inflows and outflows: $NPV = \text{PV of inflows} - \text{PV of outflows}$.

Independent Projects

Investment projects that can be implemented in any combination because the decision on one does not affect the others.

Mutually Exclusive Projects

A set of projects where only a subset (often only one) can be implemented due to legal, technological, or resource constraints.

Internal Rate of Return (IRR)

The discount rate that drives the NPV of a project to zero, representing the average periodic return earned by the project.

Profitability Index (PI)

A relative value metric calculated as the ratio of the present value of cash inflows to the present value of cash outflows: $PI = \frac{\text{PV of inflows}}{\text{PV of outflows}}$. reality.

Payback Period (PP)

The amount of time it takes for a project's cumulative cash inflows to recover the initial invested capital.

Operating Cash Flows

Cash flows earned through a company's core business activity, primarily comprising incremental revenue minus incremental operating costs and taxes.

Investment Cash Flows

Cash flows resulting from the purchase or sale of capital assets, including Capital Expenditures ($\text{CapEx}$) and Working Capital ($\text{WC}$).

Financing Cash Flows

Money exchanged between the company and its investors, including loans, interest, dividends, and proceeds from stock issuances.

Incremental Cash Flows

The specific cash flows that are a direct consequence of a project, calculated as the difference between the company's future with the project and without it.

Sunk Costs

Costs that occurred in the past and are unrecoverable; they are irrelevant for estimating the financial value of a future project.

Opportunity Cost

Foregone revenue, such as rental income from an existing facility, that will be lost if a new project is accepted.

Capital Expenditures (CapEx)

Investments in fixed assets, such as property or equipment, required for a project launch.

Working Capital (WC)

A supply of short-term assets (like cash reserves or raw materials) tied up to enable smooth project operations; it is typically recovered at the end of a project.

REIT Method

An acronym for Revenue, Expenses, Investment, and Taxes, representing a core structure for calculating Free Cash Flow: $\text{FCF} = R - E - I - T$.

Free Cash Flow (FCF)

The bottom-line cash flow of a project in a given period, representing the cash available to all investors after all operating and investment needs are met.

Bond

A debt contract obligating the borrower to make regular coupon payments and repay the principal (face value) at a specified maturity date.

Coupon Rate

The ratio of a bond's annual coupon payment to its face value, used to determine the magnitude of periodic interest payments.

Zero-coupon Bond

A debt security that makes no periodic interest payments and only pays the face value to the investor at maturity.

Yield-to-Maturity (YTM)

The annualised investment return earned by a bondholder if the bond is held until its expiration, inversely related to the bond's price.

Default Risk

The probability that a borrower or bond issuer will fail to fulfill their contractual obligation to repay interest or principal.

Interest Rate Risk

The sensitivity of a bond's price to changes in economy-wide interest rates; long-maturity and low-coupon bonds are most exposed.

Dividend Discount Model (DDM)

A stock valuation method stating that the current share price should equal the present value of all expected future dividends.

Expected Return ($E[r]$)

The average of a return distribution, representing the most likely return on an investment over a given period.

Volatility ($\text{σ}$)

The standard deviation of a return distribution, used as a measure of an asset's total risk.

Diversification

A risk management technique that combines assets with low correlation to reduce the overall volatility of a portfolio.

Efficient Frontier

A graphical representation of the set of portfolios that offer the highest expected return for every level of volatility ($\text{σ}$).

Market Portfolio

A specific efficient portfolio consisting of all assets in the economy, representing the point of tangency between the risk-free rate and the efficient frontier.

Diversifiable (Idiosyncratic) Risk

Firm-specific risk that can be eliminated through portfolio diversification.

Systematic (Non-diversifiable) Risk

Economy-wide risk shared by all companies that cannot be eliminated by diversification, such as exposure to macroeconomic shocks.

Beta ($\text{β}$)

A measure of a stock's sensitivity to market movements, representing its level of systematic risk relative to the market portfolio.

Capital Asset Pricing Model (CAPM)

An equilibrium model for the required return on an asset: $E[r_{A}] = r_{f} + \beta_{A} \times (E[r_{M}] - r_{f})$.

Security Market Line (SML)

The graphical representation of the CAPM, plotting an asset's expected return against its beta ($\text{β}$).

Financial Leverage

The use of debt in a firm's capital structure, which amplifies both expected returns and the systematic risk ($\text{β}$) borne by shareholders.

Interest Tax Credits

The tax savings realized by a corporation because interest payments on debt are tax-deductible, whereas dividends are not.

Weighted Average Cost of Capital (WACC)

The blended cost of equity and debt, adjusted for taxes, used as the discount rate for valuing levered firms: $\text{WACC} = w_{E} \times r_{E} + w_{D} \times r_{D} \times (1 - \tau)$.

Financial Distress

A condition where a firm cannot meet its mandatory debt obligations, resulting in direct legal costs and indirect costs like lost revenue and productivity.

Dividend Imputation

A tax system where shareholders receive franking credits for corporate taxes already paid, reducing the double-taxation of equity income.

Initial Public Offering (IPO)

The process where a private firm lists its shares on a public exchange for the first time to raise capital and provide liquidity to early owners.

Underpricing

A phenomenon in IPOs where the offer price is set below the first-day closing market price due to information asymmetry and risk-aversion.

Synergy

The value added in an acquisition where the combined firm's cash flows exceed the sum of the individual firms' previous cash flows.

Takeover Premium

The extra amount an acquirer pays over the target firm's market price to incentivize shareholders to sell their shares.

Share Buyback

A transaction where a company repurchases its own shares from the market, reducing equity capital and increasing leverage.