Semester 2 : week 1,3,4,5,6,8 Flashcards
(24 cards)
what is finance, what are its 4 four main economic participants and 4 major sub areas -
finance : Finance involves managing money, investments, and capital flow between individuals and businesses, enabling economic growth and personal wealth creation.
main economic participants:
Type 1 – No money, no business ideas.
Type 2 – Extra money, no business ideas (investors).
Type 3 – No money, but has viable business ideas (entrepreneurs).
Type 4 – Extra money and viable business ideas (successful business owners).
Sub areas:
Investment – Choosing stocks, bonds, and cash flow strategies.
Financial Management – Raising capital, minimizing taxes, and funding projects.
Financial Institutions & Markets – Connecting investors and businesses.
International Finance – Managing global financial risks like exchange rates and political uncertainty.
4 types of business organisations, 3 key goals, 2 key perspectives
4 types:
Sole Proprietorship – Easy to start, full control, but unlimited liability.
General Partnership – Shared profits, simple structure, but joint liability.
Public Corporation – Limited liability, large capital access, but subject to double taxation.
Hybrid Organizations (LLC, LLP) – Combines benefits of corporations and partnerships, offering limited liability and single taxation.
3 key goals:
Profit Maximization – Increasing revenue.
Market Share Growth – Expanding customer base.
Social & Environmental Responsibility – Balancing financial, social, and environmental impact (Triple Bottom Line).
2 key perspectives:
Stakeholder Perspective – Firms should satisfy all stakeholders, including employees, customers, and communities.
Shareholder Perspective – Firms should focus on maximizing shareholder wealth.
self interest and competition naturally promote economic efficiency and societal well being
what is agency relationship, common confliicts between the agents (principle agent problem), how can agents ensure goal alignment
agency relationship - A situation where principals (shareholders) hire agents (managers) to run a company on their behalf.
common conflicts - Managers prioritize job security, perks, and company growth.
Shareholders want to maximize firm value and stock price.
goal alignment - Monitoring – Hiring auditors, investment analysts, and investment banks.
Incentives – Offering equity stakes and stock options to align interests.
what is corporate governance, internal and external monitors.
corporate governance -
Corporate governance is the system of policies, laws, and incentives that ensure managers act in the best interests of shareholders.
internal monitors - Board of Directors – Hires/evaluates CEO and sets executive compensation.
Internal Auditors & Compliance Officers – Ensure ethical and legal compliance.
external monitors - Auditors – Verify financial accuracy.
Investment Analysts – Assess firms for investors.
Investment Banks – Help firms raise capital.
Credit Rating Agencies – Evaluate financial health.
Government Regulators (SEC, IRS) – Monitor corporate behavior and tax compliance.
Flashcard 1: Financial Markets & Market Types
Q1: What are the key functions of financial markets?
Q2: What is the difference between primary and secondary markets?
Q3: What are some examples of primary market transactions?
Q4: What are secondary markets essential for, list some examples
Q5: How do money markets differ from capital markets?
Q6: What types of securities are traded in money markets and capital markets?
Flashcard 1: Financial Markets & Market Types
A1: Financial markets manage the flow of funds between investors and borrowers, providing liquidity and investment opportunities.
A2:
Primary Market: Investors buy securities directly from issuers (e.g., IPOs, government bonds).
Secondary Market: Investors trade securities among themselves (e.g., stock exchanges).
A3: Examples:
Initial Public Offerings (IPO) (e.g., Saudi Aramco, Alibaba).
Seasoned Equity Offerings (SEO) – additional shares sold by companies.
New bond issues by governments or corporations.
A4:
Essential for liquidity and price discovery.
Examples: London Stock Exchange (LSE), NASDAQ, New York Stock Exchange (NYSE).
A5:
Money Markets: Short-term securities (≤1 year maturity).
Capital Markets: Long-term securities (>1 year maturity).
A6:
Money Market: Treasury bills, commercial paper, certificates of deposit.
Capital Market: Stocks, corporate bonds, government bonds.
Flashcard 2: Types of Financial Markets
Q7: What is the foreign exchange market (Forex) and why is it important?
Q8: What are the key characteristics of the derivatives market?
Q9: What is traded in the commodity market?
Q10: What are cryptocurrencies, and how are they traded?
Flashcard 2: Types of Financial Markets
A7: The foreign exchange (Forex) market allows businesses and individuals to exchange currencies, affecting global trade and investment.
A8:
The derivatives market trades contracts that derive value from underlying assets.
Includes futures, options, and swaps.
Used for hedging and speculation.
A9:
The commodity market trades raw materials like gold, oil, agricultural products.
Major exchanges: London Metal Exchange (LME), Chicago Board of Trade (CBOT).
A10:
Cryptocurrencies like Bitcoin and Ethereum trade on digital platforms.
Transactions occur on exchanges such as Coinbase, Binance, and Kraken.
Initial Coin Offerings (ICOs) raise capital for new crypto projects.
Flashcard 3: Financial Institutions (FIs) & Their Roles
Q11: What are financial institutions (FIs) and why do they exist?
Q12: What are the main types of financial institutions?
Q13: How do commercial banks generate revenue?
Q14: What are the key services offered by investment banks?
Q15: How do insurance companies make money?
Q16: What is the principal-agent problem, and how do FIs help manage it?
Flashcard 3: Financial Institutions (FIs) & Their Roles
A11: Financial institutions exist to channel funds from savers to borrowers and manage financial risks.
A12:
Commercial Banks – Provide savings accounts, loans, and payment services.
Investment Banks – Assist companies in raising capital, M&As, and trading.
Insurance Companies – Manage financial risk through policies.
Mutual Funds/Pension Funds – Pool investments for long-term growth.
A13:
Interest Spread: Charge higher interest on loans than they pay on deposits.
Fees: Earn from account services, ATMs, and transactions.
A14:
Underwriting: Help companies issue stocks/bonds.
Advisory Services: Assist in mergers and acquisitions (M&A).
Trading: Buy/sell securities, currencies, and derivatives.
A15:
Premiums: Collect payments from policyholders.
Investments: Use collected premiums to generate returns.
A16: The principal-agent problem occurs when one party (agent) makes decisions that do not align with the interests of the principal (investor/lender). FIs help by:
Screening credit risks (verifying income, assets).
Monitoring borrowers (preventing excessive risk-taking).
Flashcard 4: Interest Rates & Financial Intermediation
Q17: What is the interest rate, and how is it typically expressed?
Q18: What factors influence interest rates on individual securities?
Q19: What is the real risk-free rate (RFR), and how does it relate to inflation?
Q20: How does default or credit risk affect interest rates?
Q21: What is liquidity risk, and how does it impact financial securities?
Q22: What are some examples of benchmark interest rates?
Flashcard 4: Interest Rates & Financial Intermediation
A17: The interest rate is the cost of borrowing money, usually expressed annually (nominal rate).
A18: Factors include:
Inflation expectations.
Credit risk (higher risk = higher interest).
Liquidity risk (less liquid assets = higher interest).
Maturity period (longer-term loans = higher rates).
A19:
The real risk-free rate (RFR) is the return on a risk-free asset with no expected inflation.
Linked to Treasury bill yields.
Defined by the Fisher Effect:
𝑅
𝐹
𝑅
=
𝑖
−
𝐸
𝑥
𝑝
𝑒
𝑐
𝑡
𝑒
𝑑
𝐼
𝑛
𝑓
𝑙
𝑎
𝑡
𝑖
𝑜
𝑛
RFR=i−ExpectedInflation
A20:
Default (credit) risk refers to the chance that a borrower fails to repay.
Measured by credit rating agencies (e.g., Moody’s, S&P).
Higher default risk = higher interest rate.
A21:
Liquidity risk is the difficulty of selling an asset quickly without losing value.
Less liquid securities require a liquidity risk premium (LRP).
A22:
Bank of England Base Rate (UK).
Federal Funds Rate (US).
European Central Bank (ECB) Base Rate.
Flashcard 1: Bond Basics & Market Differences
Q1: What are the key characteristics of a bond?
Q2: How do bonds differ from equities?
Q3: What is an indenture agreement, and what key details does it include?
Q4: What are the different types of bond issuers?
Q5: What factors influence bond prices in financial markets?
Flashcard 1: Bond Basics & Market Differences
A1: A bond is a fixed-income security representing a loan from investors to a borrower, typically with periodic interest (coupon) payments and repayment of principal at maturity.
A2:
Bonds: Debt instruments, fixed returns, lower risk, priority in bankruptcy, fixed maturity.
Equities: Ownership, variable returns, higher risk, no guaranteed income, no maturity date.
A3: An indenture agreement is a legal contract outlining bond details, including:
Issuer, maturity date, coupon rate, par value, collateral, call features, covenants.
A4: Bond issuers include:
Governments (e.g., U.S. Treasury, UK Debt Office).
Corporations (financial & non-financial).
Municipalities (local governments, regions).
Special Purpose Vehicles (SPVs) (e.g., asset-backed securities).
A5: Bond prices depend on:
Interest rates (higher rates → lower bond prices).
Credit ratings (lower risk → higher price).
Market conditions (inflation, demand/supply).
Flashcard 2: Bond Valuation & Pricing
Q6: How is the price of a bond determined?
Q7: What is the formula for the present value (PV) of a bond’s cash flows?
Q8: How do you calculate the price of a zero-coupon bond?
Q9: How is the price of a coupon bond determined?
Q10: What are premium, par, and discount bonds, and how are they identified?
Flashcard 2: Bond Valuation & Pricing
A6: A bond’s price is the present value of its future cash flows (coupon payments + principal repayment) discounted at the market interest rate.
A7:
𝑃
𝑉
=
∑
𝑃
𝑀
𝑇
(
1
+
𝑖
)
𝑡
+
𝐹
𝑉
(
1
+
𝑖
)
𝑁
PV=∑
(1+i)
t
PMT
+
(1+i)
N
FV
where PMT = coupon payment, FV = face value, i = discount rate, N = number of periods.
A8: Zero-coupon bond price (no periodic coupons):
𝑃
𝑉
=
𝐹
𝑉
(
1
+
𝑖
)
𝑁
PV=
(1+i)
N
FV
Example: A zero-coupon bond with 20 years to maturity, $1,000 face value, and 6% interest (semi-annual) is:
𝑃
𝑉
=
1000
(
1.03
)
40
=
306.56
PV=
(1.03)
40
1000
=306.56
A9: Coupon bond price:
Sum of PV of annuity (coupon payments) + PV of face value.
Example: A 3-year bond with an 11.25% coupon and a 4% required return has a price of $1,203.05.
A10:
Premium bond: Price > Par (Coupon Rate > YTM).
Par bond: Price = Par (Coupon Rate = YTM).
Discount bond: Price < Par (Coupon Rate < YTM).
Flashcard 3: Bond Yields & Interest Rate Risk
Q11: What is Yield to Maturity (YTM), and how is it calculated?
Q12: How does Yield to Call (YTC) differ from YTM?
Q13: What is current yield, and how is it calculated?
Q14: How does the inverse relationship between bond prices and interest rates work?
Q15: What is interest rate risk, and why does it affect long-term bonds more than short-term bonds?
Flashcard 3: Bond Yields & Interest Rate Risk
A11: Yield to Maturity (YTM) is the total return if the bond is held until maturity, calculated by solving:
𝑃
𝑉
=
∑
𝑃
𝑀
𝑇
(
1
+
𝑖
)
𝑡
+
𝐹
𝑉
(
1
+
𝑖
)
𝑁
PV=∑
(1+i)
t
PMT
+
(1+i)
N
FV
Example: A bond with a $935 price, 5% coupon, 15-year maturity → YTM = 5.65%.
A12: Yield to Call (YTC) is the return if a callable bond is redeemed early. It assumes:
The bond is called at a specific date before maturity.
Example: A bond callable in 10 years at $1,050 → YTC = 6.27%.
A13: Current yield measures annual return from interest payments only:
𝐶
𝑢
𝑟
𝑟
𝑒
𝑛
𝑡
𝑌
𝑖
𝑒
𝑙
𝑑
=
𝐴
𝑛
𝑛
𝑢
𝑎
𝑙
𝐶
𝑜
𝑢
𝑝
𝑜
𝑛
𝐵
𝑜
𝑛
𝑑
𝑃
𝑟
𝑖
𝑐
𝑒
CurrentYield=
BondPrice
AnnualCoupon
Example: A $935 bond with a $50 annual coupon → CY = 5.35%.
A14: Inverse relationship between interest rates and bond prices:
Interest rates ↑ → Bond prices ↓.
Interest rates ↓ → Bond prices ↑.
Long-term bonds are more sensitive to interest rate changes.
A15: Interest rate risk is the risk that bond prices fall when market interest rates rise.
Longer-term bonds have higher risk than short-term bonds.
Flashcard 4: Credit Risk & Bond Ratings
Q16: What is credit risk, and how does it affect bond yields?
Q17: What are the three major credit rating agencies, and what do their ratings indicate?
Q18: What is the difference between investment-grade and speculative-grade (junk) bonds?
Q19: How do credit default swaps (CDS) help manage bond investment risk?
Q20: How do government bonds differ from corporate bonds in terms of credit risk and yield?
- key takeaways for week 4 also
Flashcard 4: Credit Risk & Bond Ratings
A16: Credit risk is the risk that the bond issuer fails to pay interest or principal.
Higher credit risk = higher yield to compensate investors.
A17: Major credit rating agencies:
Moody’s, S&P, Fitch – Rate bonds from AAA (best) to D (default).
A18:
Investment-grade bonds (AAA - BBB): Safer, lower returns.
Speculative/Junk bonds (BB - D): Higher risk, higher yields.
A19: Credit default swaps (CDS) are insurance contracts against bond defaults.
If a bond issuer defaults, the CDS compensates investors.
A20:
Government bonds: Low risk, low yield.
Corporate bonds: Higher risk, higher yield.
Yield spreads vary based on economic conditions.
Key Takeaways:
📌 Bond valuation uses PV of future cash flows.
📌 YTM, YTC, and current yield measure bond returns.
📌 Bond prices fall when interest rates rise.
📌 Credit risk affects yields; investment-grade bonds are safer.
📌 CDS help manage default risk in bond markets.
Flashcard 1: Bond Basics & Market Differences
Q1: What are the key characteristics of a bond?
Q2: How do bonds differ from equities?
Q3: What is an indenture agreement, and what key details does it include?
Q4: What are the different types of bond issuers?
Q5: What factors influence bond prices in financial markets?
Flashcard 1: Bond Basics & Market Differences
A1: A bond is a fixed-income security representing a loan from investors to a borrower, typically with periodic interest (coupon) payments and repayment of principal at maturity.
A2:
Bonds: Debt instruments, fixed returns, lower risk, priority in bankruptcy, fixed maturity.
Equities: Ownership, variable returns, higher risk, no guaranteed income, no maturity date.
A3: An indenture agreement is a legal contract outlining bond details, including:
Issuer, maturity date, coupon rate, par value, collateral, call features, covenants.
A4: Bond issuers include:
Governments (e.g., U.S. Treasury, UK Debt Office).
Corporations (financial & non-financial).
Municipalities (local governments, regions).
Special Purpose Vehicles (SPVs) (e.g., asset-backed securities).
A5: Bond prices depend on:
Interest rates (higher rates → lower bond prices).
Credit ratings (lower risk → higher price).
Market conditions (inflation, demand/supply).
Flashcard 2: Stock Trading & Market Participants (Question Side)
Q6: What are the main types of stocks, and how do they differ?
Q7: How do common stock and preferred stock compare in terms of dividends and liquidation priority?
Q8: What do the terms bid price, ask price, and bid-ask spread mean in stock trading?
Q9: What are the key differences between quantitative traders and value investors?
Q10: What is the difference between a market order and a limit order?
Flashcard 2: Stock Trading & Market Participants
A6:
Common Stock (ownership, voting rights, variable dividends).
Preferred Stock (fixed dividends, no voting rights, higher priority in bankruptcy).
A7:
Common Stock: Last priority in liquidation, dividends not guaranteed.
Preferred Stock: Higher priority than common stock but lower than bonds, fixed dividends.
A8:
Bid price: Highest price a buyer is willing to pay.
Ask price: Lowest price a seller is willing to accept.
Bid-ask spread: Difference between bid and ask price (narrow = high liquidity, wide = low liquidity).
A9:
Quantitative Traders: Use algorithms to predict stock movements.
Value Investors: Identify undervalued stocks using fundamental analysis.
A10:
Market Order: Executes immediately at the best available price.
Limit Order: Executes only at a specified price or better.
Flashcard 3: Bond Yields & Interest Rate Risk
Q11: What is Yield to Maturity (YTM), and how is it calculated?
Q12: How does Yield to Call (YTC) differ from YTM?
Q13: What is current yield, and how is it calculated?
Q14: How does the inverse relationship between bond prices and interest rates work?
Q15: What is interest rate risk, and why does it affect long-term bonds more than short-term bonds?
Flashcard 3: Stock Valuation & Dividend Discount Models (DDM)
A11: Stock price is determined by the present value of future cash flows (dividends and expected sale price).
A12: DDM assumes a stock’s value is based on future dividend payments discounted to present value.
A13: Simple DDM formula:
𝑃
0
=
𝐷
1
𝑖
P
0
=
i
D
1
where D₁ = next year’s dividend, i = required rate of return.
A14: The Constant Growth DDM (Gordon Growth Model) assumes dividends grow at a constant rate:
𝑃
0
=
𝐷
1
𝑖
−
𝑔
P
0
=
i−g
D
1
where g = dividend growth rate.
A15: Assumptions:
Growth rate (g) must be less than the required return (i).
If g ≈ i, stock price becomes very large.
If g = 0, it simplifies to the Simple DDM.
Flashcard 4: Variable Growth Models & Applications (Question Side)
Q16: Why do companies not grow at a constant rate forever?
Q17: What are the two stages of the Variable Dividend Growth Model?
Q18: How is each growth stage valued in the Variable Dividend Growth Model?
Q19: How is the terminal value (Pₙ) calculated in a variable growth model?
Q20: Why is stock valuation important for investors?
Flashcard 4: Variable Growth Models & Applications
A16: Companies do not grow at a constant rate forever due to competition, market saturation, and economic cycles.
A17: The Variable Dividend Growth Model accounts for two growth stages:
Stage 1: High growth for a limited period.
Stage 2: Perpetual stable growth.
A18:
Stage 1 (finite high growth phase) is valued using standard PV of dividends.
Stage 2 (perpetual growth) is valued using Gordon Growth Model and then discounted back.
A19: The terminal value (Pₙ) is calculated using:
𝑃
𝑛
=
𝐷
𝑛
(
1
+
𝑔
2
)
𝑖
−
𝑔
2
P
n
=
i−g
2
D
n
(1+g
2
)
Then discount Pₙ back to today using:
𝑃
0
=
∑
𝐷
𝑡
(
1
+
𝑖
)
𝑡
+
𝑃
𝑛
(
1
+
𝑖
)
𝑛
P
0
=∑
(1+i)
t
D
t
+
(1+i)
n
P
n
A20: Stock valuation helps investors decide whether a stock is overvalued, fairly priced, or undervalued, guiding buy/sell decisions.
Key Takeaways:
📌 Stocks vs Bonds – Stocks have ownership rights but variable returns; bonds have fixed returns.
📌 Stock Trading – Market orders execute instantly; limit orders set a fixed price.
📌 DDM Models – Simple DDM, Constant Growth DDM (Gordon Growth Model), and Variable Growth DDM.
📌 Stock Valuation – Present value of dividends determines stock price.
📌 Terminal Value – Used in variable growth models to estimate stock worth beyond high-growth phases.
Flashcard 1: Risk, Return & Investment Performance
Q1: What is the difference between dollar return and percentage return?
Q2: How do you calculate dollar return for an investment?
Q3: How is percentage return calculated?
Q4: What is the difference between average return and geometric mean return?
Q5: How do stocks, bonds, and cash compare in terms of historical average returns?
PercentageReturn
Flashcard 1: Risk, Return & Investment Performance
A1:
Dollar return measures absolute gains/losses in money terms.
Percentage return standardizes returns for easy comparison across investments.
A2:
DollarReturn
=
(
EndingValue
−
BeginningValue
)
+
Income
DollarReturn=(EndingValue−BeginningValue)+Income
A3:
(
EndingValue
−
BeginningValue
)
+
Income
BeginningValue
×
100
%
PercentageReturn=
BeginningValue
(EndingValue−BeginningValue)+Income
×100%
A4:
Average return is the arithmetic mean of all returns.
Geometric mean return accounts for compounding over time and is a better measure for long-term investments.
A5:
Stocks (9.6% average return) outperform bonds (4.6%) and cash securities (3.3%) over the long term.
Flashcard 2: Measuring Risk & Volatility
Q6: What is risk in finance, and how is it measured? - compare the risk between stocks bonds and treasury bills
Q7: What does standard deviation represent in risk analysis?
Q8: How do you calculate standard deviation of returns?
Q9: What is the coefficient of variation (CoV), and how is it used?
Q10: Why are stocks generally more volatile than bonds or T-bills?
𝜎
Flashcard 2: Measuring Risk & Volatility
A6: Risk refers to the uncertainty of investment returns and is quantified using standard deviation. -📌 Stocks have the highest risk and return – suitable for long-term investors willing to accept volatility.
📌 Bonds offer moderate risk and return – safer than stocks but still affected by interest rates and credit risk.
📌 T-Bills are the safest but have the lowest returns – ideal for preserving capital with near-zero risk.
A7: Standard deviation measures the variability of returns from the average return—higher SD means higher risk.
A8:
∑
(
𝑅
𝑡
−
𝑅
ˉ
)
2
𝑁
−
1
σ=
N−1
∑(R
t
−
R
ˉ
)
2
where
𝑅
𝑡
R
t
is each return and
𝑅
ˉ
R
ˉ
is the average return.
A9:
StandardDeviation
AverageReturn
CoefficientofVariation=
AverageReturn
StandardDeviation
It shows risk per unit of return—lower is better for investors.
A10: Stocks are more volatile because their prices fluctuate with market conditions, while bonds and T-bills provide more stable returns.
Flashcard 3: Portfolio Diversification & Modern Portfolio Theory
Q11: What is a portfolio, and why is diversification important?
Q12: What are the two main types of risk in a portfolio? how do you calculate total risk
Q13: How does correlation between assets impact diversification?
Q14: What is Modern Portfolio Theory (MPT), and what does the efficient frontier represent?
Q15: What is the Capital Market Line (CML), and how does it guide investor decisions?
Flashcard 3: Portfolio Diversification & Modern Portfolio Theory
A11: A portfolio is a collection of assets held by an investor. Diversification spreads risk by investing in different assets.
A12: total risk = firm specific risk (diversifiable) + market risk (systematic risk)
Firm-specific (diversifiable) risk – Affects individual companies; reduced by diversification.
Market (systematic) risk – Affects the entire market; cannot be eliminated.
A13:
+1 correlation: Assets move in sync → no diversification benefit.
0 correlation: Assets move independently → moderate diversification benefit.
-1 correlation: Assets move oppositely → best diversification.
A14:
Modern Portfolio Theory (MPT) shows that risk is reduced when combining different securities.
The efficient frontier represents the optimal portfolios with the highest return for a given risk.
A15:
The Capital Market Line (CML) shows the best combination of risk-free assets and market portfolios.
Investors should mix risk-free assets with risky portfolios for optimal returns.
Flashcard 4: Capital Asset Pricing Model (CAPM) & Beta
Q16: What is beta (β), and how does it measure risk?
Q17: How do we interpret different beta values (β > 1, β = 1, β < 1)?
Q18: What is the Security Market Line (SML), and how does it relate to CAPM?
Q19: What is the formula for CAPM, and what do its components represent?
Q20: What are the main assumptions and limitations of CAPM?
+ week 6 key takeaways
Flashcard 4: Capital Asset Pricing Model (CAPM) & Beta
A16: Beta (β) measures a stock’s sensitivity to market movements.
A17:
β > 1: Stock is more volatile than the market.
β = 1: Stock moves in line with the market.
β < 1: Stock is less volatile than the market.
A18: The Security Market Line (SML) plots expected return based on beta, showing the risk-return tradeoff.
A19: The CAPM formula:
𝐸
(
𝑅
)
=
𝑅
𝑓
+
𝛽
(
𝑅
𝑚
−
𝑅
𝑓
)
E(R)=R
f
+β(R
m
−R
f
)
where:
𝐸
(
𝑅
)
E(R) = Expected return
𝑅
𝑓
R
f
= Risk-free rate
𝑅
𝑚
R
m
= Market return
𝛽
β = Systematic risk measure
A20:
Assumptions: No taxes, rational investors, perfect information, risk-free borrowing.
Limitations: Unrealistic assumptions, weak empirical support, ignores other factors like firm size and value.
Key Takeaways:
📌 Risk & Return – Higher risk generally means higher potential returns.
📌 Diversification – Reduces firm-specific risk but not market risk.
📌 CAPM & Beta – Used to price risky assets based on their exposure to systematic risk.
📌 Efficient Portfolios – Investors should seek optimal risk-return tradeoffs along the efficient frontier.
Flashcard 1: Introduction to Capital Structure
Q1: What is capital structure, and why is it important for firms?
Q2: What are the main components of a firm’s capital structure?
Q3: How do firms decide the optimal mix of debt and equity financing?
Q4: What factors influence a firm’s capital structure decision?
Flashcard 1: Introduction to Capital Structure
A1: Capital structure refers to the mix of debt and equity financing a firm uses to fund operations and growth. It is crucial because it affects risk, cost of capital, and overall firm value.
A2: The main components are debt (loans, bonds) and equity (common and preferred shares, retained earnings).
A3: Firms determine the optimal mix by balancing cost, risk, and financial flexibility to maximize shareholder value.
A4: Factors include tax benefits of debt, bankruptcy risk, profitability, asset structure, business risk, and market conditions.
Flashcard 2: Theories of Capital Structure
Q5: What is the Modigliani-Miller theorem, and what are its key assumptions?
Q6: How does the Modigliani-Miller theorem change when taxes are introduced?
Q7: What is the Trade-off Theory of capital structure?
Q8: How does the Pecking Order Theory explain a firm’s financing choices?
Flashcard 2: Theories of Capital Structure
A5: The Modigliani-Miller theorem states that under perfect market conditions, a firm’s value is unaffected by capital structure. Key assumptions include no taxes, no bankruptcy costs, and efficient markets.
A6: When taxes are considered, debt financing becomes favorable because interest payments are tax-deductible, increasing firm value.
A7: The Trade-off Theory suggests that firms balance the tax benefits of debt against the cost of financial distress to determine an optimal capital structure.
A8: The Pecking Order Theory states that firms prefer internal financing first, then debt, and finally equity, to minimize asymmetric information problems.
Flashcard 3: Debt vs. Equity Financing
Q9: What are the advantages and disadvantages of using debt financing?
Q10: What are the advantages and disadvantages of using equity financing?
Q11: How does the cost of capital impact a firm’s financing decision?
Q12: What is financial distress, and how does it affect capital structure decisions?
Flashcard 3: Debt vs. Equity Financing
A9: Advantages of debt: Lower cost than equity, tax benefits, and retained ownership. Disadvantages: Risk of financial distress and mandatory interest payments.
A10: Advantages of equity: No mandatory repayments, lower risk of bankruptcy. Disadvantages: Higher cost, dilution of ownership, and potential loss of control.
A11: A lower cost of capital makes financing cheaper, encouraging investment. A higher cost discourages excessive borrowing.
A12: Financial distress occurs when a firm struggles to meet debt obligations, leading to potential bankruptcy, higher borrowing costs, and operational challenges.
Flashcard 4: Practical Applications and Considerations
Q13: How do firms balance risk and return when making capital structure decisions?
Q14: What role do external factors (such as interest rates and market conditions) play in capital structure choices?
Q15: How do agency costs impact capital structure decisions?
Q16: What is the significance of a firm’s debt-to-equity ratio?
Flashcard 4: Practical Applications and Considerations
A13: Firms aim to balance risk (financial stability) and return (profitability, growth potential) by adjusting their debt-equity mix based on industry standards and financial health.
A14: Interest rates affect the cost of debt. High market volatility may push firms towards conservative capital structures.
A15: Agency costs arise from conflicts between management and shareholders or debt holders, influencing how firms structure financing to align incentives.
A16: The debt-to-equity ratio indicates financial leverage. A high ratio means greater debt reliance (higher risk), while a low ratio suggests conservative financing (lower risk).
