Corporate Finance Lecture Notes

Comprehensive vocabulary flashcards covering core corporate finance concepts including valuation, agency problems, capital structure theories, market efficiency, and financial ratios.

Discounted Cash Flow (DCF) Analysis

A financial valuation method used to estimate the value of an investment based on its expected future cash flows using the core principle of the time value of money.

Discount Factor

A multiplier used to convert future cash flows into their present value.

Tax Shield

A reduction in taxable income, such as interest expense on debt, which reduces a company's tax burden.

Levered Cash Flow (LCF)

The cash flow available only to equity holders (shareholders) after accounting for interest payments and debt obligations.

Unlevered Cash Flow (UCF)

The cash flow available to both equity and debt holders before interest payments, representing a company's operational performance independent of its financing structure.

Agency Problem Type 1

A conflict of interest that arises in public corporations between the owner (principal) and the manager (agent).

Agency Problem Type 2

A conflict of interest in firms with concentrated ownership between the majority (controlling) shareholders and minority shareholders.

Agency Problem Type 3

A conflict that arises when shareholders take actions that benefit themselves at the expense of creditors.

Modern Portfolio Theory

A theory created by Markowitz suggesting that diversification by including non-correlated shares in a portfolio can eliminate unsystematic risk.

Debt Covenants

Contractual restrictions imposed by lenders to limit management actions that could increase risk.

Tunneling Strategy

A strategy where shareholders shift risk onto creditors or controlling shareholders transfer assets and profits out of a company for personal benefit at the expense of minority shareholders.

Internal Rate of Return (IRR)

The expected rate of return of an investment, representing the break-even discount rate where the Net Present Value (NPV) equals zero.

Payback Period

The time required for an investment to generate sufficient cash flow to recover its initial cost, though it ignores the time value of money and cash flows beyond this period.

Pecking Order Theory

A theory stating firms prefer internal financing first, then debt, and finally equity as a last resort to minimize costs from information asymmetry.

Trade-Off Theory

A theory suggesting firms balance the benefits of debt financing (tax shields) against the costs of financial distress and bankruptcy risk to find an optimal capital structure.

Optimal Capital Structure

The mix of debt and equity that minimizes the company's cost of capital and maximizes its firm value, defined as $Value_{Unlevered} + Tax Shield - Costs_{Financial Distress}$.

Modigliani and Miller Proposition I

States that in a perfect market with no taxes or bankruptcy costs, the value of a firm is unaffected by its capital structure.

Modigliani and Miller Proposition II

States that the cost of equity increases as a firm takes on more debt, while the Weighted Average Cost of Capital (WACC) remains constant in a world without taxes.

Capital Asset Pricing Model (CAPM)

A model calculated as $Expected return = Rf + \beta \times (Rm - Rf)$ to determine expected return based on systematic risk.

Three-Factor Model

A model adding size (SMB) and value (HML) factors to the CAPM, expressed as $Expected return = Rf + \beta_1 \times (Rm - Rf) + \beta_2 \times SMB + \beta_3 \times HML + e$.

Signaling Theory

The idea that managers use financing choices (like issuing debt or buying back shares) to communicate private information about the firm's health to less-informed investors.

Weak Form Efficiency

A market state where asset prices fully reflect all past trading information, making technical analysis ineffective.

Semi-Strong Form Efficiency

A market state where prices reflect all publicly available information, making both technical and fundamental analysis ineffective.

Strong Form Efficiency

A market state where prices reflect all information, both public and private (insider), meaning no one can consistently achieve abnormal returns.

Overinvestment

When a firm invests in projects with a negative NPV, often driven by managers pursuing personal goals over shareholder value.

Underinvestment

When a firm fails to invest in positive NPV projects due to constraints like risk aversion or high debt levels.

Payout Ratio

The proportion of earnings paid out as dividends, calculated as $\text{Payout ratio} = (\frac{\text{Dividends per share}}{\text{Earnings per share}}) \times 100$.

Dividend Yield

The ratio of a company's annual dividend per share to its share price, calculated as $\text{Dividend yield} = (\frac{\text{Annual dividend per share}}{\text{Price per share}}) \times 100$.

Total Shareholder Return (TSR)

A comprehensive measure of stock performance calculated as $TSR = \frac{(\text{ending price} - \text{beginning price} + \text{dividends})}{\text{beginning price}} \times 100$.

Beta

A measure of a stock's volatility relative to the market portfolio, reflecting its sensitivity to systematic risk.

Weighted Average Cost of Capital (WACC)

The average rate of return a company pays to its security holders, calculated as $WACC = (\frac{E}{V} \times Re) + (\frac{D}{V} \times Rd \times (1 - Tc))$.

ROE (Return on Equity)

A measure of profitability generated on shareholders' equity, calculated as $ROE = \frac{Net Income}{Shareholders' Equity}$.

ROA (Return on Assets)

A measure of how effectively a company uses its assets to generate profit, calculated as $ROA = \frac{Net Income}{Total Assets}$.

Corporate Governance

The system of relationships between the board, management, and shareholders used to direct and control a company with transparency and accountability.

Market Timing

The practice of issuing equity when stock prices are high to raise capital at a lower cost.

Leasing

A contractual arrangement where a company pays to use an asset (equipment or vehicles) for a specified period without owning it.

Mortgage

A loan used to purchase property where the property itself serves as collateral and ownership eventually transfers to the borrower.

Sharpe Ratio

A measure of the return earned in excess of the risk-free rate per unit of risk.

Abnormal Return

The difference between the actual return and the expected (normal) return, often attributed to mispricing or unexpected events.

Return on Sales (ROS)

A measure of operational efficiency calculated as $ROS = \frac{Net Income}{Sales Revenues}$.