MM Proposition I A proposition of Modigliani and Miller (MM) which states that a firm cannot change the total value of its outstanding securities by changing its capital structure proportions. Also called an irrelevance result.
MM Proposition II A proposition by Modigliani and Miller (MM) which states that the cost of equity is a linear function of the firm’s debt-equity ratio.
Market capitalization Price per share of stock multiplied by the number of shares outstanding.
Market portfolio In concept, a value-weighted index of all securities. In practice, it is an index, such as the S&P 500, that describes the return of the entire value of the stock market, or at least the stocks that make up the index. A market portfolio represents the average investor’s return.
Market risk Systematic risk. This term emphasizes the fact that systematic risk influences to some extent all assets in the market.
Market value The price at which willing buyers and sellers trade a firm’s assets.
Marketability Refers to the ease and quickness of converting an asset to cash. Also called liquidity.
Market-to-book (M/B) ratio Market price per share of common stock divided by book value per share.
Maturity date The date on which the last payment on a bond is due.
Monte Carlo simulation An exercise that identifies outcomes and probabilities and generates possible scenarios.
Multiple rates of return More than one rate of return from the same project that make the net present value of the project equal to zero. This situation arises when the IRR method is used for a project in which negative cash flows follow positive ones.
NPV Net present value.
NPV rule Invest in all positive NPV opportunities.
NPVGO model A model valuing the firm in which net present value of new investment opportunities is explicitly examined. NPVGO stands for net present value of growth opportunities.
Net cash balance Beginning cash balance plus cash receipts minus cash disbursements.
Net float Sum of disbursement float and collection float.
Net investment Gross, or total, investment minus depreciation.
Net operating losses (NOL) Losses that a firm can take advantage of to reduce taxes.
Net present value (NPV) The present value of future cash returns, discounted at the appropriate market interest rate, minus the present value of the cost of the investment.
Net present value rule An investment is worth making if it has a positive NPV. If an investment’s NPV is negative, it should be rejected.
Net working capital Current assets minus current liabilities.
Nominal cash flow A cash flow expressed in nominal terms if the actual dollars to be received (or paid out) are given.
Nominal interest rate Interest rate unadjusted for inflation.
Off-balance-sheet financing Financing that is not shown as a liability on a company’s balance sheet.
Operating cash flow Earnings before interest and depreciation minus taxes. It measures the cash generated from operations, not counting capital spending or working capital requirements.
Operating lease Type of lease in which the period of contract is less than the life of the equipment and the lessor pays all maintenance and servicing costs.
Operating leverage The degree to which a company’s costs of operation are fixed as opposed to variable. A firm with high operating costs compared to a firm with a low operating leverage, and hence relatively larger changes in EBIT with respect to a change in the sales revenue.
Opportunity cost Most valuable alternative that is given up. The rate of return used in NPV computation is an opportunity interest rate.
Par value The nominal or face value of stocks or bonds. For stock, it is a relatively unimportant value except for bookkeeping purposes.
Payback period rule An investment decision rule which states that all investment projects that have payback periods equal to or less than a particular cutoff period are accepted, and all of those that pay off in more than the particular cutoff period are rejected. The payback period is the number of years required for a firm to recover its initial investment required by a project from the cash flow it generates.
Payout ratio Proportion of net income paid out in cash dividends.
Pie model of capital structure A model of the debt-equity ratio of the firm, graphically depicted in slices of a pie that represents the value of the firm in the capital markets.
Plug A variable that handles financial slack in the financial plan.
Portfolio variance Weighted sum of the covariances and variances of the assets in a portfolio.
Preferred stock A type of stock whose holders are given certain priority over common stockholders in the payment of dividends. Usually the dividend rate is fixed at the time of issue. Preferred stockholders normally do not receive voting rights.
Present value The value of a future cash stream discounted at the appropriate market interest rate.
Present value factor Factor used to calculate an estimate of the present value of an amount to be received in a future period.
Price-to-earnings (P/E) ratio Current market price of common stock divided by current annual earnings per share.
Pro forma statements Projected income statements, balance sheets, and sources and uses statements for future years.
Profit margin Profits divided by total operating revenue. The net profit margin (net income divided by total operating revenue) and the gross profit margin (earnings before interest and taxes divided by the total operating revenue) reflect the firm’s ability to produce a good or service at a high or low cost.
Profitability index A method used to evaluate projects. It is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment.
Pure discount bond Bonds that pay no coupons and only pay back face value at maturity. Also referred to as “bullets” and “zeros.”
Q ratio or Tobin’s Q ratio Market value of firm’s assets divided by replacement value of firm’s assets.
Quick assets Current assets minus inventories.
Quick ratio Quick assets (current assets minus inventories) divided by total current liabilities. Used to measure shortterm solvency of a firm.
R squared (R2) Square of the correlation coefficient proportion of the variability explained by the linear model.
Random walk Theory that stock price changes from day to day are at random; the changes are independent of each other and have the same probability distribution.
Real cash flow A cash flow is expressed in real terms if the current, or date 0, purchasing power of the cash flow is given.
Real interest rate Interest rate expressed in terms of real goods; that is, the nominal interest rate minus the expected inflation rate.
Receivables turnover ratio Total operating revenues divided by average receivables. Used to measure how effectively a firm is managing its accounts receivable.
Repurchase agreement (repos) Short-term, often overnight, sales of government securities with an agreement to repurchase the securities at a slightly higher price.
Repurchase of stock Device to pay cash to firm’s shareholders that provides more preferable tax treatment for shareholders than dividends. Treasury stock is the name given to previously issued stock that has been repurchased by the firm.
Retained earnings Earnings not paid out as dividends.
Retention ratio Retained earnings divided by net income. Also called the plowback ratio.
Return Profit on capital investment or securities.
Return on assets (ROA) Income divided by average total assets.
Return on equity (ROE) Net income after interest and taxes divided by average common stockholders’ equity.
Risk premium The excess return on the risky asset that is the difference between expected return on risky assets and the return on risk-free assets.
SML Security market line.
SMP Security market plane.
Scenario analysis Analysis of the effect on the project of different scenarios, each scenario involving a confluence of factors.
Secondary markets Already-existing securities are bought and sold on the exchanges or in the over-the-counter market.
Security market line (SML) A straight line that shows the equilibrium relationship between systematic risk and expected rates of return for individual securities. According to the SML, the excess return on a risky asset is equal to the excess return on the market portfolio multiplied by the beta coefficient.
Security market plane (SMP) A plane that shows the equilibrium relationship between expected return and the beta coefficient of more than one factor.
Sensitivity analysis Analysis of the effect on the project when there is some change in critical variables such as sales and costs.
Simple interest Interest calculated by considering only the original principal amount.
Sinking fund An account managed by the bond trustee for the purpose of repaying the bonds.
Straight-line depreciation A method of depreciation whereby each year the firm depreciates a constant
proportion of the initial investment less salvage value.
Target payout ratio A firm’s long-run dividend-toearnings ratio. The firm’s policy is to attempt to pay out a certain percentage of earnings, but it pays a stated dollar dividend and adjusts it to the target as increases in earnings occur.
Taxable income Gross income less a set of deductions.
Time value of money Price or value put on time. Time value of money reflects the opportunity cost of investing at a risk-free rate. The certainty of having a given sum of money today is worth more than the certainty of having an equal sum at a later date because money can be put to profitable use during the intervening time.
Tobin’s Q Market value of assets divided by replacement value of assets. ATobin’s Q ratio greater than 1 indicates the firm has done well with its investment decisions.
Total asset-turnover ratio Total operating revenue divided by average total assets. Used to measure how effectively a firm is managing its assets.
Total cash flow of the firm Total cash inflow minus total cash outflow.
Treasury bond or note Debt obligations of the federal government that make semiannual coupon payments and are sold at or near par value in denominations of $1,000 or more. They have original maturities of more than one year.
Treasury stock Shares of stock that have been issued and then repurchased by a firm.
Triangular arbitrage Striking offsetting deals among three markets simultaneously to obtain an arbitrage profit.
WACC Weighted average cost of capital.
Weighted average cost of capital (WACC) The average cost of capital on the firm’s existing projects and activities. The weighted average cost of capital for the firm is calculated by weighting the cost of each source of funds by its proportion of the total market value of the firm. It is
calculated on a before- and after-tax basis.
Yield to maturity The discount rate that equates the present value of interest payments and redemption value with the present price of the bond.
Zero-coupon bonds Bonds with no coupons.
© The McGraw−Hill Companies, 2001
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