CORPORATE FINANCE

BONDS
Treasury bills (T-bills) Discounted debt instruments issued by the U.S. government.

repurchase agreement An arrangement where one firm sells some of its financial assets to another firm
with a promise to repurchase the securities at a later date.

federal funds Overnight loans from one bank to another bank.

banker’s acceptance An instrument issued by a bank that obligates the bank to pay a specified amount
at some future date.

commercial paper A discounted instrument that is a type of promissory note, or “legal” IOU, issued by
large, financially sound firms.

certificate of deposit An interest-earning time deposit at a bank or other financial intermediary

Eurodollar deposit A deposit in a foreign bank that is denominated in U.S. dollars.

money market mutual funds Pools of funds managed by investment companies that are primarily
invested in short-term financial assets.

term loan A loan, generally obtained from a bank or insurance company, on which the borrower agrees
to make a series of payments consisting of interest and principal.

coupon rate Interest paid on a bond or other debt instrument stated as a percentage of its face
(maturity) value.

government bonds Debt issued by a federal, state, or local government. municipal bonds Bonds issued
by a state or local government.

corporate bonds Long-term debt instruments issued by corporations.

mortgage bond A bond backed by tangible (real) assets. First-mortgage bonds are senior in priority to
second-mortgage bonds.

Debenture A long-term bond that is not secured by a mortgage on specific property.

subordinated debenture A bond which, in the event of liquidation, has a claim on assets only after the
senior debt has been paid off.

income bond A bond that pays interest to the holder only if the interest is earned by the firm.

putable bond A bond that can be redeemed at the bondholder’s option when certain
circumstances exist.

indexed (purchasing-power) bondA bond that has interest payments based on an inflation index to
protect the holder from loss of purchasing power.

floating-rate bond A bond whose interest rate fluctuates with shifts in the general level of interest rates.
Zero-coupon bond A bond that pays no annual interest but sells at a discount below par, thus providing
compensation to investors in the form of capital appreciation.

junk bond A high-risk, high-yield bond; used to finance mergers, leveraged buyouts, and
troubled companies.

Indenture A formal agreement (contract) between the issuer of a bond and the bondholders.

call provision A provision in a bond contract that gives the issuer the right to redeem the bonds under
specified terms prior to the normal maturity date

Sinking fund A required annual payment designed to amortize a bond issue.

conversion feature Permits bondholders to exchange their investments for a fixed number of shares of
common stock.

foreign debt Debt sold by a foreign borrower but denominated in the currency of the country where it
is sold.

Eurodebt Debt sold in a country other than the one in whose currency the debt is denominated.

LIBOR The London Interbank Offered Rate; the interest rate offered by the best London banks on
deposits of other large, very creditworthy banks.

yield to maturity (YTM) The average rate of return earned on a bond if it is held to maturity. yield to call
(YTC) The average rate of return earned on a bond if it is held until the first call date.

current (interest) yieldThe interest payment divided by the market price of the bond.

capital gains yield The percentage change in the market price of a bond over some period of time.

interest rate price risk

The risk of changes in bond prices to which investors are exposed as the result of changing interest rates

interest rate reinvestment risk The risk that income from a bond portfolio will vary because cash flows
must be reinvested at current market rates
 Stocks

cumulative dividends A protective feature on preferred stock that requires preferred dividends that
were not paid in previous years to be disbursed before any common stock dividends can be paid.

call premium  The amount in excess of par value that a company must pay when it calls a security

income stocks Stocks of firms that traditionally pay large, relatively constant dividends each year.
growth stocks Stocks that generally pay little or no dividends so as to retain earnings to help fund
growth opportunities.

proxy A document giving one person the authority to act for another; typically it gives them the power
to vote shares of common stock.

preemptive right A provision that gives existing common stockholders the right to purchase new issues
of common stock on a pro rata basis before any shares can be offered to other investors.

classified stock Common stock that is given a special designation, such as Class A, Class B, and so forth,
to meet special needs of the company. founders’ shares Stock, owned by the firm’s founders, that has
sole voting rights but generally pays out only restricted dividends (if any) for a specified number of
years.

American depository receipts (ADRs) “Certificates” that represent ownership in stocks of foreign
companies and are held in trust by banks located in the countries where the stocks are traded.

Euro stock Stock traded in countries other than the home country of the company, not including the
United States.

Yankee stock Stock issued by foreign companies and traded in the United States.

market price (value) The price at which a stock currently sells in the market.

intrinsic (theoretical) value The value of an asset that, in the mind of a particular investor, is justified by
the facts; P ⁄ 0 can be different from the asset’s current market price, its book value, or both

growth rate, g The expected annual rate of change in dividends per share.

required rate of return The minimum rate of return that stockholders consider acceptable on a
common stock.

dividend yield The next expected dividend divided by the current price of a share of stock

capital gains yield The change in price (capital gain) during a given year divided by the price at the
beginning of the year.

expected rate of return The rate of return that an individual stockholder expects to receive on a
common stock. It is equal to the expected dividend yield plus the expected capital gains yield,
constant growth model Also called the Gordon model, it is used to find the value of a stock that is
expected to experience constant growth.

nonconstant growth The part of the life cycle of a firm in which its growth is either much faster or much
slower than that of the economy as a whole

P/E ratio The current market price of a stock divided by the earnings per share

economic value added (EVA) An analytical method that seeks to evaluate the earnings generated by a
firm to determine whether they are sufficient to compensate the suppliers of funds—both the
bondholders and the stockholders

Capital Budgeting Tehniques

capital budgeting The process of planning and evaluating expenditures on assets whose cash flows are
expected to extend beyond one year.

replacement decisions Decisions whether to purchase capital assets to take the place of existing assets
to maintain or improve existing operations.

expansion decisions Decisions whether to purchase capital projects and add them to existing assets to
increase existing operations.

independent projects Projects whose cash flows are not affected by decisions made about other
projects.

mutually exclusive projects A set of projects in which the acceptance of one project means the others
cannot be accepted

post-audit A comparison of the actual and expected results for a given capital project.

net present value (NPV) The present value of an asset’s future cash flows minus its purchase price
(initial investment)

internal rate of return (IRR) The discount rate that forces the PV of a project’s expected cash flows to
equal its initial cost; IRR is the same as the YTM on a bond.

required rate of return (hurdle rate) The discount rate (cost of funds) that the IRR must exceed for a
project to be considered acceptable.

net present value (NPV) profile A graph that shows the NPVs for a project at various discount rates
(required rates of return)
reinvestment rate assumption The assumption that cash flows from a project can be reinvested (1) at
the firm’s required rate of return, if using the NPV method or (2) at the internal rate of return, if using
the IRR method.

modified IRR (MIRR) The discount rate at which the present value of a project’s cash outflows 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 required rate of return and the present value of the
cash outflows is found using the same required rate of return.

traditional payback period (PB) The length of time it takes to recover the original cost of an investment
from its unadjusted (raw) expected cash flows

discounted payback period (DPB) The length of time it takes for a project’s discounted cash flows to
repay the cost of the investment.

Project Cash Flows And Risk

incremental (marginal) cash flow The change in a firm’s net cash flow attributable to purchasing an
investment project.

sunk cost A cash outlay that has already been incurred and that cannot be recovered regardless of
whether the project is accepted or rejected.

opportunity cost The return on the best alternative use of an asset; the highest return that will not be
earned if funds are invested in a particular project.

externalities The effect accepting a project will have on the cash flows in other parts (areas) of the firm.

initial investment outlay The incremental cash flows associated with a project that are expected to
occur only at the start of a project’s life.

supplemental operating cash flows The changes in dayto-day cash flows that result from the purchase
of a capital project and continue until the firm disposes of the asset.

terminal cash flow The net cash flow that occurs at the end of the life of a project, including the cash
flows associated with (1) the final disposal of the project and (2) returning the firm’s operations to
where they were before the project was accepted.

expansion project A project that is intended to increase sales.

replacement analysis An analysis involving the decision as to whether to replace an existing asset with a
new asset
stand-alone risk The risk an asset would have if it were a firm’s only asset. It is measured by the
variability of the asset’s expected returns

sensitivity analysis A risk analysis technique in which key variables are changed and the resulting
changes in the NPV and the IRR are observed

scenario analysis A risk analysis technique in which “bad” and “good” sets of financial circumstances are
compared with a most likely, or base case, situation.

worst-case scenario An analysis in which all of the input variables are set at their worst reasonably
forecasted values.

best-case scenario An analysis in which all of the input variables are set at their best reasonably
forecasted values.

base (most likely) case An analysis in which all of the input variables are set at their most likely values.
Monte Carlo simulation A risk analysis technique in which probable future events are simulated on a
computer, generating a probability distribution that indicates the most likely outcomes

corporate (within-firm) risk Risk that does not take into consideration the effects of stockholders’
diversification; it is measured by a project’s effect on the firm’s earnings variability

beta (market) risk That part of a project’s risk that cannot be eliminated by diversification; it is
measured by the project’s beta coefficient.

project required rate of return The risk-adjusted required rate of return for an individual project

pure play method An approach used for estimating the beta of a project in which a firm identifies
companies whose only business is the product in question, determines the beta for each firm, and then
averages the betas to find an approximation of its own project’s beta.

risk-adjusted discount rate The discount rate (required rate of return) that applies to a particular risky
stream of income; it is equal to the risk-free rate of interest plus a risk premium appropriate to the level
of risk associated with a particular project’s cash flow stream.

repatriation of earnings The process of sending cash flows from a foreign subsidiary back to the
parent company

exchange rate risk The uncertainty associated with the price at which the currency from one country
can be converted into the currency of another country.

political risk The risk of expropriation (seizure) of a foreign subsidiary’s assets by the host country or of
unanticipated restrictions on cash flows to the parent company.
The Cost Of Capital
required rate of return The return that must be earned on invested funds to cover the cost of financing
such investments; also called the opportunity cost rate.

cost of capital The firm’s average cost of funds, which is the average return required by the firm’s
investors— what the firm must pay to attract funds.

capital components The particular types of capital used by the firm—that is, its debt, preferred stock,
and common equity.

after-tax cost of debt, rdT The relevant cost of new debt, taking into account the tax deductibility of
interest

cost of preferred stock, rps The rate of return investors require on the firm’s preferred stock, rps. cost
of retained earnings, rs The rate of return required by stockholders on a firm’s existing common stock.

cost of new common equity, re The cost of issuing new common stock (external equity); it is based on
the cost of retained earnings, but increased for flotation costs.

flotation costs The expenses incurred when selling new issues of securities

target (optimal) capital structure The combination (percentages) of debt, preferred stock, and common
equity that will maximize the price of the firm’s stock.

weighted average cost of  capital (WACC) A weighted average of the component costs of debt,
preferred stock, and common equity; the average cost of each dollar the firm uses to purchase (invest
in) assets.

marginal cost of capital (MCC) The cost of obtaining another dollar of new capital; the weighted average
cost of the last dollar of new capital raised.

MCC (marginal cost of capital) schedule A graph that relates the firm’s weighted average cost of each
dollar of capital to the total amount of new capital raised.

break point (BP) The dollar value of new capital that can be raised before an increase in the firm’s
weighted average cost of capital (WACC) occurs.

investment opportunity schedule (IOS) A graph of the firm’s investment opportunities ranked in order
of the projects’ internal rates of return.
Capital Structure
capital structure The combination of debt and equity used to finance a firm.

target capital structure The mix of debt, preferred stock, and common equity with which the firm plans
to finance its investments.

business risk The risk associated with the firm’s operations, ignoring any financing effects.

financial risk The portion of stockholders’ risk, over and above basic business risk, that results from the
manner in which the firm’s assets are financed.

operating leverage The presence of fixed operating costs that do not change when the level of sales
changes.

financial leverage The extent to which fixed-income securities (debt and preferred stock) are used in a
firm’s capital structure.

EPS indifference point The level of sales at which EPS will be the same whether the firm uses debt or
common stock financing.

degree of operating leverage (DOL) The percentage change in operating income (EBIT) associated with a
given percentage change in sales.

degree of financial leverage (DFL) The percentage change in earnings per share (EPS) associated with a
given percentage change in earnings before interest and taxes (EBIT)

degree of total leverage (DTL) The percentage change in EPS that results from a given percentage
change in sales; DTL shows the effects of both operating leverage and financial leverage.

times-interest-earned (TIE) ratio A ratio that measures the firm’s ability to meet its annual interest
obligations; calculated by dividing earnings before interest and taxes (EBIT) by interest charges

symmetric information The situation in which investors and managers have identical information about
the firm’s prospects.

asymmetric information The situation in which managers have different (better) information about their
firm’s prospects than do outside investors

signal An action taken by a firm’s management that provides clues to investors about how management
views the firm’s prospects.

reserve borrowing capacity The ability to borrow money at a reasonable cost when good investment
opportunities arise; firms often use less debt than specified by the optimal capital structure to ensure
that they can obtain debt capital later if necessary.
Distribution Of Retained Earnings: Dividends And Stock Repurchases

optimal dividend policy The dividend policy that strikes a balance between current dividends and future
growth, and maximizes the firm’s stock price.

dividend irrelevance theory The theory that a firm’s dividend policy has no effect on either its value or
its cost of capital.

dividend relevance theory The value of a firm is affected by its dividend policy— the optimal dividend
policy is the one that maximizes the firm’s value.

information content (signaling) hypothesis The theory that investors regard dividend changes as
signals of management’s earnings forecasts.

clientele effect The tendency of a firm to attract the type of investor who likes its dividend policy.

free cash flow hypothesis  All else equal, firms that pay dividends from cash flows that cannot be
reinvested in positive net present value projects (free cash flows) have higher values than firms that
retain free cash flows.

residual dividend policy A policy in which the dividend paid is set to equal the actual earnings minus the
amount of retained earnings necessary to finance the firm’s optimal capital budget.

stable, predictable dividend policy Payment of a specific dollar dividend each year, or periodically
increasing the dividend at a constant rate, so that the annual dollar dividend is relatively predictable
by investors.

constant payout ratio Payment of a constant percentage of earnings as dividends each year.

extra dividend A supplemental dividend paid in years when the firm does well and excess funds are
available for distribution.

declaration date The date on which the board of directors declares the amount and the specifics of the
next dividend payment.

holder-of-record date (date of record) The date on which the company opens the ownership books to
determine who will receive the next dividend; the stockholders of record on this date receive the
dividend.

ex-dividend date The date on which the right to the next dividend no longer accompanies a stock; it
usually is two working days prior to the holder-ofrecord date.

payment date The date on which a firm actually makes a dividend payment

dividend reinvestment plans (DRIPs) Plans that enable stockholders to automatically reinvest dividends
received in the stocks of the paying firms.

stock split An action taken by a firm to decrease the per-share price of its stock
stock dividends A dividend paid in the form of additional shares of stock rather than cash

stock repurchase Distribution of earnings by a firm to stockholders by repurchasing shares of its stock in
the financial markets.

Managing Short-Term Financing (Liabilities)

working capital management The management of short-term assets (investments) and short-term
liabilities (financing sources).

working capital A firm’s investment in short-term assets— cash, marketable securities, inventory, and
accounts receivable.

net working capital Current assets minus current liabilities—the amount of current assets financed by
long-term liabilities.

working capital policy Decisions regarding (1) the target levels for each current asset account and
(2) how current assets will be financed.

inventory conversion period (ICP) The amount of time a product remains in inventory in various stages
of completion.

receivables collection period (DSO) The time it takes to collect cash following a credit sale; also known
as days sales outstanding (DSO).

payables deferral period (DPO) The average length of time between the purchase of raw materials and
labor and the payment of cash for them; also known as days payables outstanding (DPO).

cash conversion cycle The length of time from the payment for the purchase of raw materials to
manufacture a product until the collection of accounts receivable associated with the sale of the product

permanent current assets Current assets’ balances that remain stable no matter the seasonal or
economic conditions.

temporary current assets Current assets that fluctuate with seasonal or cyclical variations in a firm’s
business.

maturity matching (“self-liquidating”) approach A financing policy that matches asset and liability
maturities; considered a moderate current asset financing policy.

conservative approach A policy under which all of the fixed assets, all of the permanent current assets,
and some of the temporary current assets of a firm are financed with long-term capital.

aggressive approach A policy under which all of the fixed assets of a firm are financed with long-term
capital, but some of the firm’s permanent current assets are financed with short-term nonspontaneous
sources of funds.
short-term credit Any liability originally scheduled for repayment within one year.

accruals Recurring short-term liabilities; liabilities such as wages and taxes that change spontaneously
with operations.

trade credit The credit created when one firm buys on credit from another firm.

promissory note A document specifying the terms and conditions of a loan, including the amount,
interest rate, and repayment schedule.

compensating balance (CB) A minimum checking account balance that a firm must maintain with a bank
to borrow funds— generally 10 to 20 percent of the amount of loans outstanding.

line of credit An arrangement in which a bank agrees to lend up to a specified maximum amount of
funds during a designated period.

revolving (guaranteed) credit agreement A formal, committed line of credit extended by a bank or
other lending institution.

commitment fee A fee charged on the unused balance of a revolving credit agreement to compensate
the bank for guaranteeing that the funds will be available when needed by the borrower; the fee
normally is about 0.25 percent of the unused balance.

commercial paper Unsecured, short-term promissory notes issued by large, financially sound firms to
raise funds.

secured loans Loans backed by collateral; for short-term loans, the collateral often is inventory,
receivables, or both.

Uniform Commercial Code A system of standards that simplifies procedures for establishing loan
security.

pledging receivables Using accounts receivable as collateral for a loan.

recourse The lender can seek payment from the borrowing firm when receivables’ accounts used to
secure a loan are uncollectible.

factoring The outright sale of receivables.

“free” trade credit Credit received during the discount period.

costly trade credit Credit taken in excess of “free” trade credit, whose cost is equal to the discount lost.

simple interest loan Both the amount borrowed and the interest charged on that amount are paid at
the maturity of the loan.

face value The amount of the loan, or the amount borrowed; also called the principal amount of the
loan.

quoted (simple) interest rate The annual percentage rate (APR) that is used to compute the interest
rate per period (rPER), which is used to determine dollar amount of interest that is paid on the loan.
discount interest loan A loan in which the interest, which is calculated on the amount borrowed
(principal), is paid at the beginning of the loan period; interest is paid in advance.

add-on interest Interest that is calculated and then added to the amount borrowed to obtain the total
dollar amount to be paid back in equal instalments

Managing Short-Term Assets

restricted current asset investment policy A policy under which holdings of cash and marketable
securities, inventories, and receivables are minimized.

moderate current asset investment policy A policy between the relaxed and restrictive current asset
investment policies

transactions balance A cash balance necessary for day-to-day operations; the balance associated with
routine payments and collections.

compensating balance A minimum checking account balance that a firm must maintain with a bank to
help offset the costs of services such as check clearing and cash management advice.

precautionary balance A cash balance held in reserve for unforeseen fluctuations in cash flows.

speculative balance A cash balance held to enable the firm to take advantage of any bargain purchases
that might arise unexpectedly.

cash budget A schedule showing cash receipts, cash disbursements, and cash balances for a firm over a
specified time period

target (minimum) cash balance The minimum cash balance a firm desires to maintain to conduct
business.

disbursements and receipts method (scheduling) Method of determining net cash flow by estimating
the cash disbursements and the cash receipts expected to be generated each period.

synchronized cash flows A situation in which cash inflows coincide with cash outflows, thereby
permitting a firm to hold low transactions balances.

float The difference between the balance shown in a firm’s (or individual’s) checkbook and the balance
shown on the bank’s records.

disbursement float The value of the checks that have been written and disbursed (paid) but have not
yet fully cleared through the banking system, and thus have not been deducted from the account on
which they were written.

collections float The amount of checks that have been received and deposited but have not yet been
made available to the account in which they were deposited.
net float The difference between disbursement float and collections float; the difference between the
balance shown in the company’s checkbook and the balance shown on the bank’s books.

lockbox arrangement A technique used to reduce float by having payments sent to post office boxes
located near customers.

preauthorized debit system A system that allows a customer’s bank to periodically transfer funds from
its account to a selling firm’s bank account for the payment of bills.

concentration banking A technique used to move funds from many bank accounts to a more
central cash pool to more effectively manage cash.

zero-balance account (ZBA) A special checking account used for disbursements that has a balance equal
to zero when there is no disbursement activity

controlled disbursement accounts (CDA) Checking accounts in which funds are not deposited until
checks are presented for payment, usually on a daily basis.

marketable securities Securities that can be sold on short notice without loss of principal or original
investment (liquid investments)

credit policy A set of decisions that includes a firm’s credit standards, credit terms, methods used to
collect credit accounts, and credit monitoring procedures.

credit standards Standards that indicate the minimum financial strength a customer must have to be
granted credit.

terms of credit The payment conditions offered to credit customers; these terms include the length of
the credit period and any cash discounts offered.

credit period The length of time for which credit is granted; after that time, the credit account is
considered delinquent.

cash discount A reduction in the invoice price of goods offered by the seller to encourage early
payment.

collection policy The procedures followed by a firm to collect its accounts receivable.

receivables monitoring The process of evaluating the credit policy to determine whether a shift in the
customers’ payment patterns has occurred.

days sales outstanding (DSO) The average length of time required to collect accounts receivable; also
called the average collection period.

aging schedule A report showing how long accounts receivable have been outstanding; the report
divides receivables into specified periods, which provide information about the proportion of
receivables that is current and the proportion that is past due for given lengths of time

raw materials The inventories purchased from suppliers that ultimately will be transformed into
finished goods.
work-in-process Inventory in various stages of completion; some work-in-process is at the very
beginning of the production process while some is at the end of the process.

finished goods Inventories that have completed the production process and are ready for sale.

stockout Occurs when a firm runs out of inventory and customers arrive to purchase the product.

carrying costs The costs associated with having inventory, which include storage costs, insurance, cost of
tying up funds, and so on; these costs generally increase in proportion to the average amount of
inventory held.

ordering costs The costs of placing an order; the cost of each order generally is fixed regardless of the
average size of the inventory.

economic (optimum) ordering quantity (EOQ) The optimal quantity that should be ordered; it is this
quantity that will minimize the total inventory costs. EOQ model A formula for determining the order
quantity that will minimize total inventory costs

reorder point The level of inventory at which an order should be placed.

safety stock Additional inventory carried to guard against unexpected changes in sales rates or
production/ shipping delays during the reorder period.

quantity discount A discount from the purchase price that is offered when inventory is ordered in large
quantities.

redline method An inventory control procedure where a red line is drawn around the inside of an
inventory-stocked bin to indicate the reorder point level.

computerized inventory control system A system of inventory control in which a computer is used to
determine reorder points and to adjust inventory balances. J

ust-in-time system A system of inventory control in which a manufacturer coordinates production with
suppliers so that raw materials of components arrive just as they are needed in the production process.

outsourcing The practice of purchasing components rather than making them in-house
Financial Planning and Control
financial planning The projection of sales, income, and assets, as well as the determination of the
resources needed to achieve these projections. financial control The phase in which financial plans are
implemented; control deals with the feedback and adjustment process required to ensure adherence to
plans and modification of plans because of unforeseen changes.

sales forecast A forecast of a firm’s unit and dollar sales for some future period; generally based on
recent sales trends plus forecasts of the economic prospects for the nation, region, industry, and so
forth.

projected (pro forma) balance sheet method A method of forecasting financial requirements based on
forecasted financial statements

spontaneously generated funds Funds that are obtained from routine business transactions.

additional funds needed (AFN) Funds that a firm must raise externally through new borrowing, by
selling new stock, or by some combination of these actions.

financing feedbacks The effects on the income statement and balance sheet of actions taken to finance
forecasted increases in assets.

lumpy assets Assets that cannot be acquired in small increments, but instead must be obtained in large,
discrete amounts

operating breakeven analysis An analytical technique for studying the relationship between sales
revenues, operating costs, and operating profits

operating breakeven point (QOpBE and SOpBE) Represents the level of production and sales at which
net operating income is zero; it is the point at which revenues from sales just equal total operating costs.

operating leverage The existence of fixed operating costs such that a change in sales will produce a
larger change in operating income (EBIT).

degree of operating leverage (DOL) The percentage change in NOI (or EBIT) associated with a given
percentage change in sales.

financial breakeven analysis Determining the operating income (EBIT) the firm needs to just cover all of
its financing costs and produce earnings per share equal to zero.

financial breakeven point (EBITFinBE) The level of EBIT at which EPS equals zero

financial leverage The existence of fixed financial costs such as interest and preferred dividends; occurs
when a change in EBIT results in a larger change in EPS.
degree of financial leverage (DFL) The percentage change in EPS that results from a given percentage
change in EBIT

degree of total leverage (DTL) The percentage change in EPS that results from a 1 percent change in
sales