Masters in Finance - Key Terms and
Questions and Answers Grade A+ 2023
Capital Structure - -The combination of debt and equity used to finance a company's assets and
operations.
Debt comes in the form of bond issues or loans, while equity may come in the form of common
stock, preferred stock, or retained earnings.
When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity
(D/E) ratio, which provides insight into how risky a company's borrowing practices are. Usually,
a company that is heavily financed by debt has a more aggressive capital structure and therefore
poses a greater risk to investors. This risk, however, may be the primary source of the firm's
growth.
D/E ratio is calculated by dividing total liabilities by total equity.
Assuming that a company has access to capital (e.g. investors and lenders), they will want to
minimize their cost of capital. This can be done using a weighted average cost of capital
(WACC) calculation.
-Internal Rate of Return (IRR) - -- the discount rate that makes the NPV of an investment zero
- the annual rate of growth that an investment is expected to generate.
- the higher an internal rate of return, the more desirable an investment is to undertake.
- IRR is ideal for analyzing capital budgeting projects to understand and compare potential rates
of annual return over time.
Can be easy calculated in excel. Need to determine the original cost of the investment, expected
future cash flows, and the WACC. From there, you can use the =IRR function to calculate IRR.
If IRR = 66%, this means that if the WACC was 66%, the NPV would equal zero.
Example: The IRR for Project A is 12%. If I invest in Project A, I can expect an average annual
return of 12%.
- the reinvestment assumption says that the IRR assumes interim cash flows are reinvested at the
same rate as the IRR
-Bond Prices and Interest Rates - -- inverse relationship. When the cost of borrowing money rises
(when interest rates rise), bond prices usually fall, and vice-versa.
- Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving
up demand and the price of the bond.
- Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate
paid by a bond, resulting in a decline in its price.
-Net Present Value (NPV) - -- the sum of the present values of expected future cash flows from
an investment, minus the cost of that investment
- the difference between an investment's market value and its cost.
, - One important drawback of NPV analysis is that it makes assumptions about future events that
may not be reliable.
- NPV seeks to determine the present value of an investment's future cash flows above the
investment's initial cost. The discount rate element of the NPV formula discounts the future cash
flows to the present-day value. If subtracting the initial cost of the investment from the sum of
the cash flows in the present day is positive, then the investment is worthwhile.
-discount rate - -- the interest rate used in discounted cash flow (DCF) analysis to determine the
present value of future cash flows.
- the discount rate expresses the time value of money and can make the difference between
whether an investment project is financially viable or not.
- While investing in standard assets, like treasury bonds, the risk-free rate of return is often used
as the discount rate.
- On the other hand, if a business is assessing the viability of a potential project, the weighted
average cost of capital (WACC) may be used as a discount rate.
- As this implies, when the discount rate is higher, money in the future will be worth less than it
is today. It will have less purchasing power.
- When considering an investment, the investor should use the opportunity cost of putting their
money to work elsewhere as an appropriate discount rate. That is the rate of return that the
investor could earn in the marketplace on an investment of comparable size and risk. WACC is
another option.
-WACC (weighted average cost of capital) - -- represents a firm's average cost of capital from all
sources, including common stock, preferred stock, bonds, and other forms of debt.
- The weighted average cost of capital is a common way to determine required rate of return
because it expresses, in a single number, the return that both bondholders and shareholders
demand in order to provide the company with capital. A firm's WACC is likely to be higher if its
stock is relatively volatile or if its debt is seen as risky because investors will demand greater
returns.
- Uses: NPV calc, evaluating mergers, DCF
-CAPM (Capital Asset Pricing Model) - -- r(asset) = rf + B(rm-rf) where rf = risk free rate, B =
beta of asset, Rm = return on the market, Rm-Rrf = risk premium. Expected return of a security
based on its systematic risk
- The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and
the time value of money are compared to its expected return.
- The risk-free rate in the CAPM formula accounts for the time value of money. The other
components of the CAPM formula account for the investor taking on additional risk.
- beta is a measure of how an individual asset moves when the overall stock market increases or
decreases.. If a stock is riskier than the market, it will have a beta greater than one. If a stock has
a beta of less than one, the formula assumes it will reduce the risk of a portfolio.
- the market risk premium, which is the return expected from the market above the risk-free rate.
-How do you value a company? - -1. Intrinsic value (discounted cash flow valuation):
Questions and Answers Grade A+ 2023
Capital Structure - -The combination of debt and equity used to finance a company's assets and
operations.
Debt comes in the form of bond issues or loans, while equity may come in the form of common
stock, preferred stock, or retained earnings.
When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity
(D/E) ratio, which provides insight into how risky a company's borrowing practices are. Usually,
a company that is heavily financed by debt has a more aggressive capital structure and therefore
poses a greater risk to investors. This risk, however, may be the primary source of the firm's
growth.
D/E ratio is calculated by dividing total liabilities by total equity.
Assuming that a company has access to capital (e.g. investors and lenders), they will want to
minimize their cost of capital. This can be done using a weighted average cost of capital
(WACC) calculation.
-Internal Rate of Return (IRR) - -- the discount rate that makes the NPV of an investment zero
- the annual rate of growth that an investment is expected to generate.
- the higher an internal rate of return, the more desirable an investment is to undertake.
- IRR is ideal for analyzing capital budgeting projects to understand and compare potential rates
of annual return over time.
Can be easy calculated in excel. Need to determine the original cost of the investment, expected
future cash flows, and the WACC. From there, you can use the =IRR function to calculate IRR.
If IRR = 66%, this means that if the WACC was 66%, the NPV would equal zero.
Example: The IRR for Project A is 12%. If I invest in Project A, I can expect an average annual
return of 12%.
- the reinvestment assumption says that the IRR assumes interim cash flows are reinvested at the
same rate as the IRR
-Bond Prices and Interest Rates - -- inverse relationship. When the cost of borrowing money rises
(when interest rates rise), bond prices usually fall, and vice-versa.
- Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving
up demand and the price of the bond.
- Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate
paid by a bond, resulting in a decline in its price.
-Net Present Value (NPV) - -- the sum of the present values of expected future cash flows from
an investment, minus the cost of that investment
- the difference between an investment's market value and its cost.
, - One important drawback of NPV analysis is that it makes assumptions about future events that
may not be reliable.
- NPV seeks to determine the present value of an investment's future cash flows above the
investment's initial cost. The discount rate element of the NPV formula discounts the future cash
flows to the present-day value. If subtracting the initial cost of the investment from the sum of
the cash flows in the present day is positive, then the investment is worthwhile.
-discount rate - -- the interest rate used in discounted cash flow (DCF) analysis to determine the
present value of future cash flows.
- the discount rate expresses the time value of money and can make the difference between
whether an investment project is financially viable or not.
- While investing in standard assets, like treasury bonds, the risk-free rate of return is often used
as the discount rate.
- On the other hand, if a business is assessing the viability of a potential project, the weighted
average cost of capital (WACC) may be used as a discount rate.
- As this implies, when the discount rate is higher, money in the future will be worth less than it
is today. It will have less purchasing power.
- When considering an investment, the investor should use the opportunity cost of putting their
money to work elsewhere as an appropriate discount rate. That is the rate of return that the
investor could earn in the marketplace on an investment of comparable size and risk. WACC is
another option.
-WACC (weighted average cost of capital) - -- represents a firm's average cost of capital from all
sources, including common stock, preferred stock, bonds, and other forms of debt.
- The weighted average cost of capital is a common way to determine required rate of return
because it expresses, in a single number, the return that both bondholders and shareholders
demand in order to provide the company with capital. A firm's WACC is likely to be higher if its
stock is relatively volatile or if its debt is seen as risky because investors will demand greater
returns.
- Uses: NPV calc, evaluating mergers, DCF
-CAPM (Capital Asset Pricing Model) - -- r(asset) = rf + B(rm-rf) where rf = risk free rate, B =
beta of asset, Rm = return on the market, Rm-Rrf = risk premium. Expected return of a security
based on its systematic risk
- The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and
the time value of money are compared to its expected return.
- The risk-free rate in the CAPM formula accounts for the time value of money. The other
components of the CAPM formula account for the investor taking on additional risk.
- beta is a measure of how an individual asset moves when the overall stock market increases or
decreases.. If a stock is riskier than the market, it will have a beta greater than one. If a stock has
a beta of less than one, the formula assumes it will reduce the risk of a portfolio.
- the market risk premium, which is the return expected from the market above the risk-free rate.
-How do you value a company? - -1. Intrinsic value (discounted cash flow valuation):
