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overvalued securities by analyzing fundamental information,
formance of a portfolio of 30 “blue-chip” stocks.
such as earnings, asset values, and business prospects.
Du Pont system: A breakdown of ROE and ROA into compo-
funded debt: Debt with more than 1 year remaining to maturity.
nent ratios.
future value: Amount to which an investment will grow after
economic order quantity: Order size that minimizes total inven-
earning interest.
tory costs.
futures contract: Exchange-traded promise to buy or sell an
economic value added (EVA): Term used by the consulting firm
asset in the future at a prespecified price.
Stern Stewart for profit remaining after deduction of the cost
fx: Abbreviation for foreign exchange; also abbreviated forex.
of the capital employed.
GAAP: See generally accepted accounting principles.
effective annual interest rate: Interest rate that is annualized
general cash offer: Sale of securities open to all investors by an
using compound interest.
already-public company.
efficient capital markets: Financial markets in which security
generally accepted accounting principles (GAAP): Procedures
prices rapidly reflect all relevant information about asset val-
for preparing financial statements.
ues.
income statement: Financial statement that shows the revenues,
equivalent annual cost: The cost per period with the same pres-
expenses, and net income of a firm over a period of time.
ent value as the cost of buying and operating a machine.
inflation: Rate at which prices as a whole are increasing.
eurobond: Bond that is marketed internationally.
information content of dividends: Dividend increases send good
eurodollars: Dollars held on deposit in a bank outside the
news about cash flow and earnings. Dividend cuts send bad
United States.
news.
EVA: See economic value added.
GLOSSARY 637


market risk: Economywide (macroeconomic) sources of risk that
initial public offering (IPO): First offering of stock to the gen-
affect the overall stock market. Also called systematic risk.
eral public.
market risk premium: Risk premium of market portfolio. Dif-
interest rate parity: Theory that forward premium equals inter-
ference between market return and return on risk-free Trea-
est rate differential.
sury bills.
interest tax shield: Tax savings resulting from deductibility of
market value added: Market value of equity minus book value.
interest payments.
market-value balance sheet: Financial statement that uses the
internal growth rate: Maximum rate of growth without external
market value of all assets and liabilities.
financing.
maturity premium: Extra average return from investing in long-
internal rate of return (IRR): Discount rate at which project
versus short-term Treasury securities.
NPV = 0.
merger: Combination of two firms into one, with the acquirer
internally generated funds: Cash reinvested in the firm; depre-
assuming assets and liabilities of the target firm.
ciation plus earnings not paid out as dividends.
MM dividend-irrelevance proposition: Theory that under ideal
international Fisher effect: Theory that real interest rates in all
conditions, the value of the firm is unaffected by dividend
countries should be equal, with differences in nominal rates
policy.
reflecting differences in expected inflation.
MM™s proposition I (debt irrelevance proposition): The value of
in the black: Making a profit.
a firm is unaffected by its capital structure.
in the red: Making a loss.
MM™s proposition II: The required rate of return on equity in-
investment grade: Bonds rated Baa or above by Moody™s or
creases as the firm™s debt-equity ratio increases.
BBB or above by Standard & Poor™s.
Modified Accelerated Cost Recovery System (MACRS): Depre-
issued shares: Shares that have been issued by the company.
ciation method that allows higher tax deductions in early years
IPO: See initial public offering.
and lower deductions later.
IRR: See internal rate of return.
money market: Market for short-term financial assets.
junk bond: Bond with a rating below Baa or BBB.
mutually exclusive projects: Two or more projects that cannot be
law of one price: Theory that prices of goods in all countries
pursued simultaneously.
should be equal when translated to a common currency.
net float: Difference between payment float and availability
lease: Long-term rental agreement.
float.
leveraged buyout (LBO): Acquisition of the firm by a private
net present value (NPV): Present value of cash flows minus ini-
group using substantial borrowed funds.
tial investment.
limited liability: The owners of the corporation are not person-
net working capital: Current assets minus current liabilities.
ally responsible for its obligations.
net worth: Book value of common stockholders™ equity plus pre-
line of credit: Agreement by a bank that a company may borrow
ferred stock.
at any time up to an established limit.
nominal interest rate: Rate at which money invested grows.
liquidation: Sale of bankrupt firm™s assets.
NPV: See net present value.
liquidation value: Net proceeds that would be realized by selling
NYSE: New York Stock Exchange.
the firm™s assets and paying off its creditors.
open account: Agreement whereby sales are made with no for-
liquidity: Ability of an asset to be converted to cash quickly at
mal debt contract.
low cost.
operating leverage: Degree to which costs are fixed.
lock-box system: System whereby customers send payments to a
operating risk (business risk): Risk in firm™s operating income.
post office box and a local bank collects and processes
opportunity cost of capital: Expected rate of return given up by
checks.
investing in a project.
long position: Purchase of an investment.
opportunity cost: Benefit or cash flow forgone as a result of an
majority voting: Voting system in which each director is voted
action.
on separately.
OTC: See over-the-counter.
management buyout (MBO): Acquisition of the firm by its own
outstanding shares: Shares that have been issued by the com-
management in a leveraged buyout.
pany and are held by investors.
M&A: Abbreviation for mergers and acquisitions.
over-the-counter (OTC): Shares traded off an organized ex-
marginal tax rate: Additional taxes owed per dollar of addi-
change. Also used to refer to the Nasdaq market.
tional income.
par value: Value of security shown on certificate.
market index: Measure of the investment performance of the
partnership: Business owned by two or more persons who are
overall market.
personally responsible for all its liabilities.
market portfolio: Portfolio of all assets in the economy. In prac-
payback period: Time until cash flows recover the initial invest-
tice a broad stock market index, such as the Standard & Poor™s
ment of the project.
Composite, is used to represent the market.
638 GLOSSARY


reorganization: Restructuring of financial claims on failing
payment float: Checks written by a company that have not yet
firm to allow it to keep operating.
cleared.
payout ratio: Fraction of earnings paid out as dividends. residual income: Also called economic value added. Profit
P/E: See price-earnings multiple. minus cost of capital employed.
pecking order theory: Firms prefer to issue debt rather than eq- restructuring: Process of changing the firm™s capital structure
uity if internal finance is insufficient. without changing its assets.
percentage of sales models: Planning model in which sales fore- retained earnings: Earnings not paid out as dividends.
casts are the driving variables and most other variables are rights issue: Issue of securities offered only to current stock-
proportional to sales. holders.
perpetuity: Stream of level cash payments that never ends. risk premium: Expected return in excess of risk-free return as
planning horizon: Time horizon for a financial plan. compensation for risk.
plowback ratio: Fraction of earnings retained by the firm. S&P: Abbreviation for Standard & Poor™s stockmarket index.
poison pill: Measure taken by a target firm to avoid acquisition; scenario analysis: Project analysis given a particular combina-
for example, the right for existing shareholders to buy addi- tion of assumptions.
tional shares at an attractive price if a bidder acquires a large seasoned offering: Sale of securities by a firm that is already
holding. publicly traded.
preferred stock: Stock that takes priority over common stock in SEC: See Securities and Exchange Commission.
regard to dividends. secondary market: Market in which already issued securities are
present value (PV): Value today of a future cash flow. traded among investors.
present value of growth opportunities (PVGO): Net present secured debt: Debt that has first claim on specified collateral in
value of a firm™s future investments. the event of default.
price-earnings (P/E) multiple: Ratio of stock price to earnings
Securities and Exchange Commission (SEC): Federal agency
per share.
responsible for regulation of securities markets in the United
primary market: Market for the sale of new securities by corpo-
States.
rations.
security market line: Relationship between expected return and
prime rate: Benchmark interest rate charged by banks.
beta.
private placement: Sale of securities to a limited number of in-
semi-strong-form efficiency: Market prices reflect all publicly
vestors without a public offering.
available information.
pro formas: Projected or forecasted financial statements.
sensitivity analysis: Analysis of the effects of changes in sales,
profitability index: Ratio of net present value to initial invest-
costs, and so on, on project profitability.
ment.
shark repellent: Amendments to a company charter made to
project cost of capital: Minimum acceptable expected rate of re-
forestall takeover attempts.
turn on a project given its risk.
shelf registration: A procedure that allows firms to file one reg-
prospectus: Formal summary that provides information on an
istration statement for several issues of the same security.
issue of securities.
shortage costs: Costs incurred from shortages in current assets.
protective covenant: Restriction on a firm to protect bond-
short position: The sale of an investment, particularly by some-
holders.
one who does not yet own it.
proxy contest: Takeover attempt in which outsiders compete
simple interest: Interest earned only on the original investment;
with management for shareholders™ votes. Also called proxy
no interest is earned on interest.
fight.
simulation analysis: Estimation of the probabilities of different
purchasing power parity (PPP): Theory that the cost of living in
possible outcomes, e.g., from an investment project.
different countries is equal, and exchange rates adjust to off-
sinking fund: Fund established to retire debt before maturity.
set inflation differentials across countries.
sole proprietor: Sole owner of a business which has no partners
put option: Right to sell an asset at a specified exercise price on
and no shareholders. The proprietor is personally liable for all
or before the exercise date.
the firm™s obligations.
PV: See present value.
spot rate of exchange: Exchange rate for an immediate transac-
random walk theory: Security prices change randomly, with no
tion.
predictable trends or patterns.
spread: Difference between public offer price and price paid by
rate of return: Total income per period per dollar invested.
underwriter.
real assets: Assets used to produce goods and services.
stakeholder: Anyone with a financial interest in the firm.
real interest rate: Rate at which the purchasing power of an in-
Standard & Poor™s Composite Index: Index of the investment
vestment increases.
performance of a portfolio of 500 large stocks. Also called the
real options: Options embedded in real assets.
S&P 500.
real value of $1: Purchasing power“adjusted value of a dollar.
GLOSSARY 639


treasury stock: Stock that has been repurchased by the company
standard deviation: Square root of variance. Another measure of
and held in its treasury.
volatility.
underpricing: Issuing securities at an offering price set below
statement of cash flows: Financial statement that shows the
the true value of the security.
firm™s cash receipts and cash payments over a period of time.
underwriter: Firm that buys an issue of securities from a com-
stock dividend: Distribution of additional shares to a firm™s
pany and resells it to the public.
stockholders.
unique risk: Risk factors affecting only that firm. Also called di-
stock repurchase: Firm buys back stock from its shareholders.
versifiable risk.
stock split: Issue of additional shares to firm™s stockholders.
variable costs: Costs that change as the level of output changes.
straight-line depreciation: Constant depreciation for each year
variance: Average value of squared deviations from mean. A
of the asset™s accounting life.
measure of volatility.
strong-form efficiency: Market prices rapidly reflect all infor-
venture capital: Money invested to finance a new firm.
mation that could in principle be used to determine true value.
WACC: See weighted-average cost of capital.
subordinated debt: Debt that may be repaid in bankruptcy only
warrant: Right to buy shares from a company at a stipulated
after senior debt is paid.
price before a set date.

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