D367 Innovation in Finance - Set 4 - Part 1

Correct Answer: A statement used to calculate the company’s profits

Financial leverage refers to using borrowed funds to increase the potential return on an investment, but it also increases the risk if the returns are lower than expected.

Correct Answer: A series of equal payments made at regular intervals

An annuity involves consistent payments made over a fixed period, often seen in retirement accounts or insurance products.

Correct Answer: To measure a company’s ability to meet short-term obligations

Liquidity ratios, such as the current ratio, help assess whether a company can quickly convert assets to cash to cover its short-term liabilities.

Correct Answer: The degree to which a firm uses fixed costs in production

Operating leverage measures the extent to which a company uses fixed costs in its operations. Higher operating leverage means more potential for profit but also higher risk.

Correct Answer: A bond that does not pay interest but is sold at a discount

Zero-coupon bonds do not make periodic interest payments. Instead, they are issued at a discount and redeemed at face value upon maturity.

Correct Answer: The volatility of a security relative to the market

Beta measures a stock’s volatility in relation to the market. A beta of 1 indicates that the stock moves with the market, while a beta greater than 1 shows more volatility.

Correct Answer: To maximize shareholder wealth

The primary objective of corporate finance is to maximize the value of the company’s stock and, therefore, the wealth of its shareholders.

Correct Answer: Current assets / Current liabilities

The current ratio measures a company’s ability to pay short-term liabilities with its short-term assets, providing insight into its liquidity.

Correct Answer: The belief that stock prices reflect all available information

According to the EMH, it is impossible to consistently outperform the market through stock picking, as prices already incorporate all known information.

Correct Answer: The interest paid on loans and bonds

The cost of debt is the effective rate a company pays on its borrowed funds, which is typically the interest on bonds or loans.

Correct Answer: A constant stream of equal cash flows that continues indefinitely

Perpetuities are financial instruments that pay a fixed amount forever, often used in valuing preferred stock.

Correct Answer: The efficiency of a company’s use of its assets to generate profit

ROA shows how effectively a company is using its assets to generate earnings by comparing net income to total assets.

Correct Answer: To spread investments across different asset classes to reduce risk

Diversification involves spreading investments across various assets to reduce the overall risk of the portfolio by not relying on a single investment’s performance.

Correct Answer: The combination of debt and equity used to finance a firm

Capital structure refers to how a firm finances its overall operations and growth, typically using a mix of debt and equity.

Correct Answer: The average rate a company expects to pay on its total financing

WACC represents the company’s overall cost of capital, weighted by the proportion of debt and equity in the firm’s capital structure.

Correct Answer: The value of a company’s assets minus its liabilities

Book value represents the net value of a company based on its balance sheet, calculated by subtracting liabilities from assets.

Correct Answer: The value of a company’s outstanding shares

Market capitalization is calculated by multiplying the current stock price by the total number of outstanding shares, providing an estimate of the company’s size.

Correct Answer: A method for valuing a company based on its dividends and growth

The DDM estimates the present value of a company’s future dividends and is often used to value stocks in companies with stable dividend policies.

Correct Answer: The rate at which the present value of future cash flows equals the initial investment

IRR is the discount rate that makes the net present value of all cash flows from a particular project equal to zero. It is commonly used in capital budgeting.

Correct Answer: To allocate resources efficiently for long-term investments

Capital budgeting is the process by which a firm evaluates and selects long-term investment projects based on their potential to generate positive returns.