FM flashcards

An incremental cost is an extra cost

A sunk cost is a cost that has already been incurred and does not change as a result of the investment decision. It is therefore not relevant.

What is the definition of the Internal Rate of Return of a project?

The Internal Rate of Return is that rate of interest at which the Net Present Value of the project is zero.

An annuity is an equal cash flow each year.

A perpetuity is an equal cash flow each year for ever.

The nominal cash flows are the actual cash flows after adjusting for inflation.

The real cost of capital is the cost of capital ignoring any inflation. (The actual (or nominal) cost of capital is the real cost of capital as adjusted for inflation.)

The equivalent annual cost is the present value of the first replacement cycle divided by the annuity discount factor for the replacement period.

Capital rationing is the situation where there is a limit on the amount of capital available for investment.

Hard capital rationing is when capital availability is limited by the amount that lenders are prepared to lend.

Soft capital rationing is when the company itself limits the amount that it is prepared to borrow.

The profitability index for a project is the NPV of the project divided by the amount of the initial investment.

In the situation of single period capital rationing, when the projects are divisible, on what basis are the available projects ranked?

The projects are ranked on the basis of their profitability index ( = NPV of the project divided by the amount of the initial investment)

Risk is the situation where there are several possible outcomes and probabilities can be assigned to the outcomes. Uncertainly is the situation where there are several possible outcomes but where probabilities can not be assigned.

The operating cycle is the inventory days + receivables days - payables days.

Over-capitalisation is the situation where the working capital of a business is too high.

Overtrading is where a company expands rapidly but does not have enough capital to fund the required increase in the working capital. This leads to liquidity problems.

Non-recourse factoring is where the factor suffers any irrecoverable debts (i.e. the company using the factor is guaranteed to have no bad debts).

Invoice discounting is where a particular invoice (or invoices) is used as security for a loan.

* Transaction motive * Precautionary motive * Speculative motive

Name two cash management models.

* The Baumol model * The Miller-Orr model

Aggressive funding is financing most of the current assets with short-term finance.

Conservative funding is financing most of the current assets with long-term finance.

* Translation risk * Transaction risk * Economic risk

With fixed interest, the rate of interest is fixed and does not change. With floating interest, the rate of interest changes.

The yield curve shows the relationship between the yield (return) on debt and the time to maturity.

An FRA is an agreement whereby the interest rate is fixed now for a loan or deposit starting on a future date.

An IRG is an agreement whereby a maximum interest rate is fixed now for a loan starting on a future date (or a minimum interest rate in the case of a deposit starting on a future date).

A rights issue is an issue of new shares offered to existing shareholders.

Systematic risk is the risk due to general economic factors (such as the rate of inflation). It exists in all investments but the level of systematic risk is different for different types of business (business sectors). This risk cannot be diversified away.

Unsystematic risk is the risk due to factors within a particular business. This risk can be diversified away by creating a portfolio of investments.

The asset beta measures the risk of the business itself, ignoring the effect of any gearing in the business. The equity beta measures the risk of a share in the business (including the risk resulting from any gearing).

Debt borrowing where at the date of repayment the investor has the choice of taking cash or a fixed number of shares in the company.

Financial gearing measures the level of debt borrowing (and therefore interest payments) in a business. Operating gearing measures the level of fixed operating costs (as opposed to variable costs) in a business.

According to Modigliani and Miller without tax, What will happen to the weighted average cost of capital as the level of gearing within the business changes?

The weighted average cost of capital will remain constant at all levels of gearing.

According to Modigliani and Miller with tax, What will happen to the weighted average cost of capital as the level of gearing within the business changes?

The weighted average cost of capital will fall with higher levels of gearing.

A scrip dividend is where the company allows its shareholders to take their dividends in the form of new shares rather than cash.

The PE ratio is the market value per share divided by the earnings per share.

A higher PE ratio suggests that investors are expecting higher future growth.

* Weak form efficiency * Semi-strong form efficiency * Strong form efficiency

Dividends received and the market value of the shares.

Maximising is achieving maximum returns. Satisficing is achieving enough to satisfy shareholders.

* Internal (employees and managers) * Connected (shareholders, lenders, customers, suppliers, competitors) * External (government, communities, regulatory bodies)

* Economy * Efficiency * Effectiveness

The Just in Time approach aims to minimise inventory levels by improving quality and producing to customer order.

The model sets upper and lower control limits on cash. Cash in excess of the uppoer limit is transferred to deposit or short-term investments.

When the lower limit is reached, cash is withdrawn from deposit.

Purchasing power parity assumes that the exchange rate between two currencies depends on the relative inflation rates – that identical goods must cost the same.

Interest rate parity assumes that the exchange rate between two currencies depends on the relative interest rates in the two countries.

Leading is paying early and lagging is delaying payment – depending on the expected movement in the exchange rates.

A forward rate is an exchange rate quoted today to apply to conversion of a fixed amount on a fixed future date.

A Muduraba is a kind of partnership where one partner provides all the capital and the other provides the management. Profits are share in a pre-agreed ratio, but losses are sufferred only by the provider of the capital.

Musharaka is a relationship between two or more parties who contribute the capital of a business. They share profits in pre-agreed ratios, but they shares losses strictly in proportion to the capital invested.

Ijara is effectively the same as lease finance. The bank allows the customer to use the asset for a fixed period at a fixed price. The bank is responsible for major maintenance, and the lessee is responsible for general maintenance.

Venture capital is money invested in companies with high-growth potential. The venture capital investors take shares in the company, often contibute to the management, and always intend to grow the company and to then sell their shares.

The theory argues that shareholders are indifferent between getting dividends or capital growth and that therefore the level of dividends is irrelevant.

The residual theory argues that the timing of dividends is irrelevant – that a smaller dividend now will result in more retention and therefore more growth, leading to a larger dividend in the future.

A cum div price means that the purchaser of a share will also receive the next dividend. An ex div price means that the purchaser of a share will not receive the next dividend (it will go to the previous owner of the share).