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preferred stock

a hybrid security with characteristics of both common stock and bonds. Preferred stock is similar to common stock in that it has no fixed maturity date, the nonpayment of dividends does not bring on bankruptcy, and dividends are not deductible for tax purposes. Preferred stock is similar to bonds in that dividends are stated as a percent of par value and limited to the contractually stated amount.

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cumulative feature

a requirement that all past, unpaid preferred stock dividends be paid before any common stock dividends are declared.

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protective provisions

provisions for preferred stock that protect the preferred stockholders’ investment in the firm. The provisions generally allow for voting in the event of nonpayment of dividends, or they restrict the payment of common stock dividends if sinking-fund payments are not met or if the firm is in financial difficulty.

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convertible preferred stock

preferred shares that can be converted into a predetermined number of shares of common stock, if investors so choose.

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call provision

a provision that entitles the corporation to repurchase its preferred stock from investors at stated prices over specified periods.

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sinking-fund provision

a protective provision often contained in bond or preferred stock contracts that requires the firm periodically to set aside an amount of money for the retirement of the stock or bond issue. This money is then used to purchase the preferred stock or bonds in the open market or through the use of the call provision, whichever method is cheaper.

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common stock

shares that represent ownership in a corporation.

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limited liability

a protective provision whereby the investor is not liable for more than the amount he or she has invested in the firm.

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proxy

a means of voting in which a designated party is provided with the temporary power to vote for the signee at the corporation’s annual meeting.

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majority voting

voting in which each share of stock allows the shareholder one vote and each position on the board of directors is voted on separately. As a result, a majority of shares has the power to elect the entire board of directors.

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cumulative voting

voting in which each share of stock allows the shareholder a number of votes equal to the number of directors being elected. The shareholder can then cast all of his or her votes for a single candidate or split them among the various candidates.

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preemptive right

the right entitling the common shareholder to maintain his or her proportionate share of ownership in the firm.

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right

a certificate issued to common stockholders giving them an option to purchase a stated number of shares from a security offering at a specified price.

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profit-retention rate

the percentage of a firm’s earnings that it retains and reinvests within the firm.

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dividend-payout ratio

dividends as a percentage of earnings.

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required rate of return

minimum rate of return necessary to attract an investor to purchase or hold a security or invest in a project.

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flotation costs

the costs incurred by the firm when it issues securities to raise funds.

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financial policy

the firm’s policies regarding the sources of financing it plans to use and the particular mix (proportions) in which they will be used.

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weighted average cost of capital

an average of the individual costs of financing used by the firm.

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cost of debt

the rate that has to be received from an investment in order to achieve the required rate of return for the creditors. This rate must be adjusted for the fact that an increase in interest payments will result in lower taxes. The cost is based on the debt holders’ opportunity cost of debt in the capital markets.

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capital structure

the mix of long-term sources of funds used by the firm. For most firms sources include debt, preferred stock, and common stock. Capital structure is typically described using percent of funds raised from each source of financing.

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capital budgeting

the decision-making process with respect to investment in fixed assets.

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payback period

the number of years it takes to recapture a project’s initial outlay.

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net present value (NPV)

the present value of an investment’s annual free cash flows less the investment’s initial outlay.

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profitability index (PI)

the ratio of the present value of an investment’s future free cash flows to the investment’s initial outlay.

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internal rate of return (IRR)

the rate of return that the project earns. For computational purposes, the internal rate of return is defined as the discount rate that equates the present value of the project’s free cash flows with the project’s initial cash outlay.

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modified internal rate of return (MIRR)

the discount rate that equates the present value of the project’s future free cash flows with the terminal value of the cash inflows.

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capital rationing

placing a limit on the dollar size of the capital budget.

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mutually exclusive projects

projects that, if undertaken, would serve the same purpose. Thus, accepting one will necessarily mean rejecting the others.

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equivalent annual annuity (EAA)

an annuity cash flow that yields the same present value as the project’s NPV.

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incremental cash flow

the difference between the cash flows a company will produce both with and without the investment it is thinking about making.

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working capital

a concept traditionally defined as a firm’s investment in current assets. Net working capital is a related term which equals working capital minus current liabilities.

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project standing alone risk

a project’s risk ignoring the fact that much of this risk will be diversified away.

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contribution-to-firm risk

the amount of risk that the project contributes to the firm as a whole; this measure considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets but ignores the effects of diversification of the firm’s shareholders.

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systematic risk

the risk related to an investment return that cannot be eliminated through diversification. Systematic risk results from factors that affect all stocks. Also called market risk or nondiversifiable risk.

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risk-adjusted discount rate

a discount rate that is adjusted upward to compensate for added risk. The capital asset pricing model is a popular tool for making such risk adjustments.

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pure play method

a method for estimating a project’s or division’s beta that attempts to identify publicly traded firms engaged solely in the same business as the project or division.

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scenario analysis

a simulation approach for gauging a project’s risk under the worst, best, and most likely outcomes. The firm’s management examines the distribution of the outcomes to determine the project’s level of risk and then makes the appropriate adjustment.

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sensitivity analysis

a method for dealing with risk whereby the change in the distribution of possible net present values or internal rates of return for a particular project resulting from a change in one particular input variable is calculated. This is done by changing the value of one input variable while holding all other input variables constant.

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compound interest

the situation in which interest paid on an investment during the first period is added to the principal. During the second period, interest is earned on the original principal plus the interest earned during the first period.

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annuity

a series of equal dollar payments made for a specified number of years.

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annuity due

an annuity in which the payments occur at the beginning of each period.

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perpetuity

an annuity with an infinite life.

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amortized loan

a loan that is paid off in equal periodic payments.

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risk

potential variability in future cash flows.

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standard deviation

a statistical measure of the spread of a probability distribution calculated by squaring the difference between each outcome and its expected value, weighting each value by its probability, summing over all possible outcomes, and taking the square root of this sum.

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company-unique risk

the risk related to an investment that can be eliminated through diversification. Unsystematic risk is the result of factors that are unique to the particular firm or project.

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market risk

the risk related to an investment return that cannot be eliminated through diversification. Systematic risk results from factors that affect all stocks.

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holding-period return (historical or realized rate of return)

the rate of return earned on an investment, which equals the dollar gain divided by the amount invested.

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beta

the relationship between an investment’s returns and the market’s returns. This is a measure of the investment’s nondiversifiable risk.

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portfolio beta

the average of the individual stock betas held in a portfolio. It is a weighted average of the individual securities’ betas, with the weights being equal to the proportion of the portfolio invested in each security.

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asset allocation

identifying and selecting the asset classes appropriate for a specific investment portfolio and determining the proportions of those assets within the portfolio.

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risk-free rate of return

the rate of return on a risk-free investments. The interest rates on short-term U.S. government securities are commonly used to measure this rate.

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required rate of return

minimum rate of return necessary to attract an investor to purchase or hold a security or invest in a project.

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expected rate of return

(1) the discount rate that equates the present value of the future cash flows (interest and maturity value) of a bond with its current market price. It is the rate of return an investor will earn if the bond is held to maturity. (2) The rate of return investors expect to receive on an investment by paying the existing market price of the security.

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risk premium

the additional return an investor requires for assuming risk.

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capital asset pricing model (CAPM)

an equation stating that the expected rate of return on an investment (in this case a stock) is a function of (1) the risk-free rate, (2) the investment’s systematic risk, and (3) the expected risk premium for the market portfolio of all risky securities.

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security market line

a line that reflects minimum acceptable return for a given level of systematic risk associated with a security.

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bond

a long-term (10-year or more) promissory note issued by the borrower, promising to pay the owner of the security a predetermined, fixed amount of interest each year.

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debenture

a form of corporate debt that is backed only by the promise of the borrower to pay and not by a mortgage or a lien on any specific property.

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subordinated debenture

a debenture that is subordinated to other debentures in terms of its payments in case of insolvency.

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mortgage bond

a bond secured by a lien on real property.

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Eurobond

a bond issued in a country different from the one in which the currency of the bond is denominated; for example, a bond issued in Europe or Asia by an American company that pays interest and principal to the lender in U.S. dollars.

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convertible bond

a debt security that can be converted into a firm’s stock at a prespecified price.

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par value

for a bond, par value is the amount that the firm must repay when the bond comes due (matures); for a stock, par value is the arbitrary value a firm assigns to each share of stock when new shares are issued to investors. Any amount received from the stock sale that is above par value is paid-in-capital.

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coupon interest rate

the interest rate contractually owed on a bond as a percent of its par value.

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fixed-rate bond

a bond that pays a fixed amount of interest to the investor each year.

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zero coupon bond

a bond issued at a substantial discount from its $1,000 face value and that pays no interest. As a consequence, the bondholder receives his total return from investing in the bond in the form of price appreciation.

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maturity

the length of time until the bond issuer returns the par value to the bondholder and terminates the bond.

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callable bond (redeemable bond)

a bond where the issuer has an option to call (redeem) the bond before it matures. This is usually done if interest rates decline below what the firm is paying on the bond.

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call protection period

a prespecified time period during which the issuer cannot recall a bond.

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indenture

the legal agreement between the firm issuing bonds and the bond trustee who represents the bondholders, providing the specific terms of the loan agreement.

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junk bond (high yield bond)

any bond rated BB or below.

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book value

the value of an asset as shown on the firm’s balance sheet. It represents the historical cost of the asset rather than its current market value or replacement cost.

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liquidation value

the dollar sum that could be realized if an asset were sold.

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market value

the value observed in the marketplace.

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intrinsic, or economic, (fair value)

the present value of an asset’s expected future cash flows. This value is the amount the investor considers to be fair value, given the amount, timing, and riskiness of future cash flows.

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efficient market

a market in which the prices of securities at any instant in time fully reflect all publicly available information about the securities and their actual public values.

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expected rate of return

(1) the discount rate that equates the present value of the future cash flows (interest and maturity value) of a bond with its current market price. It is the rate of return an investor will earn if the bond is held to maturity. (2) The rate of return investors expect to receive on an investment by paying the existing market price of the security.

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yield to maturity

the rate of return a bondholder will receive if the bond is held to maturity. (It is equivalent to the expected rate of return.)

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current yield

the ratio of a bond’s annual interest payment to its market price.

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interest rate risk

the variability in a bond’s value caused by changing interest rates.

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discount bond

a bond that sells at a discount, or below par value.

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premium bond

a bond that is selling above its par value is said to be selling at a premium.

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business risk

the risk of the firm’s future earnings that is a direct result of the particular line of business chosen by the firm.

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financial risk

risk driven by the presence of fixed finance costs in the firm’s capital structure (as opposed to variable finance costs such as dividends declared and paid).

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operating leverage

results from operating costs that are fixed and do not vary with the level of firm sales.

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financial leverage

results from the firm’s use of sources of financing that require a fixed rate of return. The primary example of such a form of financing is fixed interest rate debt whereby the firm must pay predetermined interest and principal on specified dates.

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variable or direct costs

expenses that vary in total as output changes.

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fixed or indirect costs

the expenses of the firm that do not vary with the level of firm sales. An example would be salaries paid to the firm’s management team.

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optimal capital structure

the mix of sources of debt and equity sources of capital that minimizes the firm’s composite cost of capital (maximizes the common stock price) for raising a given amount of funds.

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debt capacity

the maximum amount of debt that the firm can include in its capital structure and still maintain its current credit rating.

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agency costs

the lost value a firm’s security holders face where there are conflicts of interest between managers and the security holders.

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residual dividend theory

a theory that a company’s dividend payment should equal the cash left after financing all the firm’s investments that have positive net present values.

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clientele effect

the belief that individuals and institutions will invest in companies whose dividend payouts match their particular needs for current versus future cash flow. For example, those that need current income will invest in companies that have high dividend payouts.

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information asymmetry

the notion that investors do not know as much about the firm’s operations as the firm’s management.

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agency costs

the lost value a firm’s security holders face where there are conflicts of interest between managers and the security holders.

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expectations theory

the notion that investor reactions to a managerial decision are based on their assessment of the effect of the action on stock price. For example, the announcement of a higher dividend not only indicates that more cash will be received by investors this quarter but may also signal to investors that the firm’s future prospects have improved.

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constant dividend payout ratio

a dividend payment policy in which the percentage of earnings paid out in dividends is held constant. The dollar amount fluctuates from year to year as profits vary.

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stable dollar dividend per share

a dividend policy that maintains a relatively stable dollar dividend per share over time.

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