Financial Management Exam Review

Capital Budgeting

The process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth.

Capital Expenditure

An outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year.

Operating Expenditure

An outlay of funds by the firm resulting in benefits received within 1 year.

Independent Projects

Projects whose cash flows are unrelated to (or independent of) one another; the acceptance of one does not eliminate the others from further consideration.

Mutually Exclusive Projects

Projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

Unlimited Funds

The financial situation in which a firm is able to accept all independent projects that provide an acceptable return.

Capital Rationing

The financial situation in which a firm has only a fixed number of dollars available for capital expenditures, and numerous projects compete for these dollars.

Accept-Reject Approach

The evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion.

Ranking Approach

The ranking of capital expenditure projects on the basis of some predetermined measure, such as the rate of return.

Payback Period

The amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows.

Net Present Value (NPV)

A sophisticated capital budgeting technique; found by subtracting a project’s initial investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital.

Internal Rate of Return (IRR)

A sophisticated capital budgeting technique; the discount rate that equates the NPV of an investment opportunity with $0 (because the present value of cash inflows equals the initial investment); it is the rate of return that the firm will earn if it invests in the project and receives the given cash inflows.

Net Present Value Profiles

Graphs that depict a project’s NPVs for various discount rates.

Conflicting Rankings

Conflicts in the ranking given a project by NPV and IRR, resulting from differences in the magnitude and timing of cash flows.

Risk (in capital budgeting)

The uncertainty surrounding the cash flows that a project will generate or, more formally, the degree of variability of cash flows.

Scenario analysis

A behavioral approach that uses several possible alternative outcomes (scenarios), to obtain a sense of the variability of returns, measured here by NPV.

Exchange rate risk

The danger that an unexpected change in the exchange rate between the dollar and the currency in which a project’s cash flows are denominated will reduce the market value of that project’s cash flow.

Political risk

Firms that make investments abroad may find that the host-country government can limit the firm’s ability to return profits back home. Governments can seize the firm’s assets, or otherwise interfere with a project’s operation.

Risk-adjusted discount rates (RADR)

Rates of return that must be earned on a given project to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s share price.

CAPM Formula

rj = RF + [bj ´ (rm – RF)] where rj = required return on asset j RF = risk-free rate of return bj = beta coefficient for asset j rm = return on the market portfolio of assets

Annualized net present value (ANPV) approach

An approach to evaluating unequal-lived projects that converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount (in NPV terms).

Leverage

The effects that fixed costs have on the returns that shareholders earn; higher leverage generally results in higher, but more volatile returns.

Fixed costs

Costs that do not rise and fall with changes in a firm’s sales. Firms have to pay these fixed costs whether business conditions are good or bad.

Capital structure

The mix of long-term debt and equity maintained by the firm.

Sources of Capital

All of the items on the right-hand side of the firm’s balance sheet, excluding current liabilities, are sources of capital.

Two components of total capital

Debt capital and Equity capital

Lenders

They take the least risk of any contributors of long-term capital; therefore Lenders demand relatively lower returns.

Equity Capital

Unlike debt capital, which the firm must eventually repay, equity capital remains invested in the firm indefinitely—it has no maturity date.

Two basic sources of equity capital

Preferred stock and common stock equity, which includes common stock and retained earnings.

Debt ratio

Total liabilities ÷ total assets

Times interest earned ratio

EBIT ÷ interest

Mortgage payment to Gross Income example

Mort. pay./Gross income = $1,400/$5,380 = 26%

Optimal capital structure range

Research suggests that there is an optimal capital structure range.

M and M theory

In 1958, Franco Modigliani and Merton H. Miller demonstrated algebraically that, assuming perfect markets, the capital structure that a firm chooses does not affect its value.

Benefit of debt financing

The major benefit of debt financing is the tax shield, which allows interest payments to be deducted in calculating taxable income.

Probability of Bankruptcy

The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due depends largely on its level of both business risk and financial risk.

Business risk

The risk to the firm of being unable to cover its operating costs.

Financial risk

The risk to the firm of being unable to cover required financial obligations.

Asymmetric information

The situation in which managers of a firm have more information about operations and future prospects than do investors.

Pecking order

A hierarchy of financing that begins with retained earnings, which is followed by debt financing and finally external equity financing.

Signal

A financing action by management that is believed to reflect its view of the firm’s stock value; generally, debt financing is viewed as a positive signal that management believes the stock is “undervalued,” and a stock issue is viewed as a negative signal that management believes the stock is “overvalued.”

NOPAT

Net operating profits after taxes, which is the after-tax operating earnings available to the debt and equity holders, EBIT ´ (1 – T)

WACC

Weighted average cost of capital

Payout Policy

The decisions that a firm makes regarding whether to distribute cash to shareholders, how much cash to distribute, and the means by which cash should be distributed.

P&G’s Dividend History

P&G has paid dividends every year for more than a century, and it increased its dividend in every year from 1956–2010.

Open-market share repurchase

A share repurchase program in which firms simply buy back some of their outstanding shares on the open market.

Tender offer repurchase

A repurchase program in which a firm offers to repurchase a fixed number of shares, usually at a premium relative to the market value

Dutch Auction repurchase

A repurchase method in which the firm specifies how many shares it wants to buy back and a range of prices at which it is willing to repurchase shares.

Dividend reinvestment plans (DRIPs)

Plans that enable stockholders to use dividends received on the firm’s stock to acquire additional shares—even fractional shares—at little or no transaction cost.

Ex dividend stock price theory

The stock price should fall by exactly the amount of the dividend.

Growth Firm Dividend Policy

A growth firm is likely to have to depend heavily on internal financing through retained earnings, so it is likely to pay out only a very small percentage of its earnings as dividends.

Constant-payout-ratio dividend policy

A dividend policy based on the payment of a certain percentage of earnings to owners in each dividend period.

Firm’s dividend payout ratio

The percentage of each dollar earned that a firm distributes to the owners in the form of cash. It is calculated by dividing the firm’s cash dividend per share by its earnings per share.

Regular dividend policy

A dividend policy based on the payment of a fixed-dollar dividend in each period.

Target dividend-payout ratio

A dividend policy under which the firm attempts to pay out a certain percentage of earnings as a stated dollar dividend and adjusts that dividend toward a target payout as proven earnings increases occur.

Stock dividend

The payment, to existing owners, of a dividend in the form of stock.

Stock split

A method commonly used to lower the market price of a firm’s stock by increasing the number of shares belonging to each shareholder.

Reverse stock split

A method used to raise the market price of a firm’s stock by exchanging a certain number of outstanding shares for one new share.