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FA - FINAL
Chapters 10, 11, 12, 13
61
Business
Undergraduate 2
05/17/2011
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Term
Capital Component
 Definition
One of the types of capital used by firms to raise funds.
Term
Weighted Average Cost of Capital (WACC)
 Definition
A weighted average of the component costs of debt, preferred stock, and common equity.
Term
Before-Tax Cost of Debt
 Definition
The interest rate the firm must pay on new debt.
Term
After-Tax Cost of Debt
 Definition
The relevant cost of new debt, taking into account the tax deductibility of interest; used to calculate the WACC.
Term
Cost of Preferred Stock
 Definition
The rate of return investors require on the firm's preferred stock. Cost of preferred stock is calculated as the preferred dividend divided by the current price.
Term
Cost of Retained Earnings
 Definition
The rate of return required by stockholders on a firm's common stock.
Term
Cost of New Common Stock
 Definition
The cost of external equity based on the cost of retained earnings but increased for flotation costs.
Term
Flotation Cost
 Definition
The percentage cost of issuing new common stock.
Term
Flotation Cost Adjustment
 Definition
The amount that must be added to cost of retained earnings to account for flotation costs to find cost of new common stock.
Term
Retained Earnings Breakpoint
 Definition
The amount of capital raised beyond which new common stock must be issued.
Term
Capital Budgeting
 Definition
The process of planning expenditures on assets with cash flows that are expected to extend beyond one year.
Term
Strategic Business Plan
 Definition
A long-run plan that outlines in broad terms the firm's basic strategy for the next 5 to 10 years.
Term
Net Present Value (NPV)
 Definition
A method of ranking investment proposals using the NPV, which is equal to the present value of future net cash flows, discounted at the cost of capital.
Term
Independent Projects
 Definition
Projects with cash flows that are not affected by the acceptance or nonacceptance of other projects.
Term
Mutually Exclusive Projects
 Definition
A set of projects where only one can be accepted.
Term
Internal Rate of Return (IRR)
 Definition
The discount rate that forces a project's NPV to equal zero.
Term
Multiple IRRs
 Definition
The situation where a project has two or more IRRs.
Term
Modified IRR (MIRR)
 Definition
The discount rate at which the present value of a project's cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm's cost of capital.
Term
Net Present Value Profile
 Definition
A graph showing the relationship between a project's NPV and the firm's cost of capital.
Term
Crossover Rate
 Definition
The cost of capital at which the NPV profiles of two projects cross and thus, at which he projects' NPVs are equal.
Term
Payback Period
 Definition
The length of time required for an investment's net revenues to cover its cost.
Term
Discounted Payback
 Definition
The length of time required for an investment's cash flows, discounted at the investment's cost of capital, to cover its cost.
Term
Incremental Cash Flow
 Definition
A cash flow that will occur if an only if the firm takes on a project.
Term
Sunk Cost
 Definition
A cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.
Term
Opportunity Cost
 Definition
The best return that can be earned on assets the firm already owns id those assets are not used for the new project.
Term
Externality
 Definition
An effect on the firm or the environment that is not reflected in the project's cash flows.
Term
Cannibalization
 Definition
The situation when a new project reduces cash flows that the firm would otherwise have had.
Term
Stand-Alone Risk
 Definition
The risk an asset would have if it were a firm's only asset and if investors owned only one stock. It is measured by the variability of the asset's expected returns.
Term
Corporate (Within-Firm) Risk
 Definition
Risk considering the firm's diversification but not stockholder diversification. It is measured by a project's effect on uncertainty about the firm' expected future returns.
Term
Market (Beta) Risk
 Definition
Considers both firm and stockholder diversification. It is measured by the project's beta coefficient.
Term
Risk-Adjusted Cost of Capital
 Definition
The cost of capital appropriate for a given project, given the riskiness of the project. The greater the risk, the higher the cost of capital.
Term
Sensitivity Analysis
 Definition
Percentage change in NPV resulting from a given percentage change in an input variable, other things held constant.
Term
Base-Case NPV
 Definition
The NPV when sales and other input variables are set equal to their most likely (or base-case) values.
Term
Scenario Analysis
 Definition
A risk analysis technique in which "bad" and "good" sets of financial circumstances are compared with a most likely, or base-case, situation.
Term
Base-Case Scenario
 Definition
An analysis in which all of the input variables are set at their most likely values.
Term
Worst-Case Scenario
 Definition
An analysis in which all of the input variables are set at their worst reasonable forecasted values.
Term
Best-Case Scenario
 Definition
An analysis in which all of the input variables are set at their best reasonably forcasted values.
Term
Monte Carlo Simulation
 Definition
A risk analysis technique in which probable future events are simulated on a computer, generating, estimated rates of return and risk indexes.
Term
Real Option
 Definition
The right but not the obligation to take some action in the future.
Term
Abandonment Option
 Definition
The option to abandon a project if operating cash flows turn out to be lower than expected. This option can raise expected profitability and lower project risk.
Term
Decision Tree
 Definition
A diagram that lays out different branches that are the result of different decisions made or the result of different economic situations.
Term
Option Value
 Definition
The difference between the expected NPVs with and without the relevant option. It is the value that is not accounted for in a traditional NPV analysis. A positive option value expands the firm's opportunities.
Term
Optimal Capital Budget
 Definition
The annual investment in long-term assets that maximizes the firm's value.
Term
Capital Rationing
 Definition
The situation in which a firm can raise only a specified, limited amount of capital regardless of how many good projects it has.
Term
Post-Audit
 Definition
A comparison of actual versus expected results for a given capital project.
Term
Class Life
 Definition
The specified life of assets under the MACRS system.
Term
Annual Depreciation Rates
 Definition
The annual expense accountants charge against income for "wear and tear" of an asset. For tax purposes, the IRS provides that appropriate MACRS rates be used that are dependent on an asset's class life.
Term
Half-Year Convention
 Definition
Assumes assets are used for half the first year and half the last year.
Term
Optimal Capital Structure
 Definition
The capital structure that maximizes a firm's stock price.
Term
Target Capital Structure
 Definition
The mix of debt, preferred stock, and common equity the firm wants to have.
Term
Business Risk
 Definition
The riskiness inherent on the firm's operations if it uses no debt.
Term
Operating Leverage
 Definition
The extent to which fixed costs are used in a firm's operations.
Term
Operating Breakeven
 Definition
The ouptut quantity at which EBIT = 0.
Term
Financial Risk
 Definition
An increase in stockholder's risk, over and above the firm's basic business risk, resulting from the use of financial leverage.
Term
Financial Leverage
 Definition
The extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure.
Term
Unlevered Beta
 Definition
The firm's beta coefficient if it has no debt.
Term
Trade-Off Theory
 Definition
The capital structure theory that states that firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy.
Term
Symmetric Information
 Definition
The situation where investors and managers have identical information about firms' prospects.
Term
Asymmetric Information
 Definition
The situation where managers have different (better) information about firms' prospects than investors.
Term
Signal
 Definition
An action taken by a firm's management that provides clues to investors about how management views the firm's prospects.
Term
Reserve Borrowing Capacity
 Definition
The ability to borrow money at a reasonable cost when good investment opportunities arise. Firms often use less debt than specified by the MM optimal capital structure in "normal" times to ensure that they can obtain debt capital later if necessary.
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