Glossary  

A   B   C   D   E   F   G   H   I   J   K   L   M   N   O   P   Q   R   S   T   U   V   W   X   Y   Z     

Agency problem   A problem that arises in an agency relationship due to inefficient or ineffective contracting.

Agency relationship   A contractual relationship in which one party (the principal) hires another (the agent) to perform a task.

Amortization table or schedule   A table showing how much of each loan payment is allocated to interest and how much is allocated to repayment of the original principal.

Annuity   Two or more equal, periodic cash flows.

back to top


Balance sheet   Statement of financial position of the firm for a point in time.

Beta   The measure of an asset's risk relative to the market portfolio; a measure of systematic risk.

Bond   A long-term debt security. An investor buying a bond in the primary market is essentially lending money to a corporation. Bonds generally make interest payments every six months and pay the par value to the investor at maturity.

Bond rating   A measure of a bond's default risk provided by a rating agency such as Moody's Investors Service or Standard & Poor's Corporation.

back to top

Call feature   A bond or preferred stock feature that allows the corporate issuer to buy back the bond prior to maturity or allows the corporate issuer to buy back preferred stock.

Capital asset pricing model (CAPM)   The equation for the security market line showing that the expected return on an asset is related to its systematic risk.

Capital budgeting   The decision-making process used in the acquisition of long-term physical assets.

Capital gain   The gain on the sale of a long-term asset over and above the original cost.

Capital market line   A line connecting the risk-free rate of return and the market portfolio. The slope measures the increase in return for an increase in risk.

Capital structure   A firm's proportion of long-term financing provided by debt, preferred stock, and common equity.

Coefficient of variation   The ratio of standard deviation of returns to expected return.

Collateral   An asset representing security for a loan; if the loan fails, the asset can be sold to help repay the loan.

Common stock   Represents ownership in a corporation.

Compound interest   Interest paid on interest previously earned as well as being paid on principal.

Compounding   The process of a present value earning interest and growing to a future value where the interest is earned on previously paid interest.

Correlation coefficient   A numerical measure of the extent to which the returns of two assets move together over time. The range is from -1.0 to +1.0.

Cost of capital   The minimum rate of return a firm needs to earn on investments to succeed. It is the rate of return required to keep the firm's investors satisfied.

Coupon rate   The interest rate offered by a bond. The coupon rate is an annual rate multiplied times the par value to obtain the annual coupon payment. Corporate bonds usually pay half the annual coupon payment every six months.

Cumulative dividends   The type of dividends paid by most preferred stocks. If a corporation misses a cumulative dividend on preferred stock, then the missed dividend accumulates. The corporation can never again pay a common stock dividend until all missed accumulated preferred dividends have been paid.

back to top

Debenture   A bond that is not secured by collateral. It is backed by a corporation's cash flow.

Default   The inability of a borrower to make interest or principal payments to bondholders.

Depreciation   The apportionment of the cost of a long-term asset over some specified period of time for the purpose of financial reporting or taxes.

Discount rate   The interest rate used in the process of discounting.

Discounted payback period   How many years it takes for a capital budgeting project's net cash flows, measured as a present value, to recover the project cost. The present values of the project's net cash flows are usually computed using the firm's appropriate required rate of return.

Discounting   The process of finding the present value of a future single payment or stream of payments. The interest rate used in the process is called the discount rate.

Diversification   Holding two or more assets to maximize return and minimize risk.

Dividend decision   A decision made by the firm regarding how much dividends will be paid and when.

Dividend yield   A percentage return computed by dividing a company's annual dividend by the price of the stock.

back to top

Effective annual rate   The actual interest rate paid or received on an annual basis is referred to as the effective annual rate. For example, a 6 percent nominal annual rate compounded monthly is equivalent to a 6.17 percent effective annual rate because $100 invested at this rate for one year will earn $6.17 in interest per year.

Efficient portfolio   The portfolio providing the highest return for a given level of risk.

Equity yield rate   The rate of return an investor earns on a prospect during the holding period.

Expected value   The weighted average of potential outcomes.

back to top

Fair share   The number of hotel rooms available at the subject hotel divided by the total number of available rooms in the competitive market.

Fee simple interest   The highest ownership interest in real estate, including all rights to its use and enjoyment.

Financing decision   A decision made by the firm regarding how assets will be paid for. Represents one of the three major financial decisions of the firm.

Flotation costs   Any costs a firm incurs to issue or float a new security. Includes investment banking and legal fees as well as any other relevant costs. Same as issuance costs.

Forward contract   An agreement regarding the sale of an asset at a future date for a negotiated price.

Futures contract   Similar to a forward contract with some key exceptions, including standardized amounts, dates of delivery, and no cash payment requirement at time of contract.

Future value   The value at some future point in time of a single cash amount or several cash amounts that occur at an earlier point in time.

back to top

Holding period of return   Rate of return on an investment over a given period.

back to top

Income statement   Statement of firm performance in terms of revenues and expenses for a period of time, typically a month or a year.

Indenture   The contract setting out the agreement between investors and the issuing corporation for a bond. It details the covenants restricting future actions of the issuing corporation and also explains the various features of the bond.

Independent project   A capital budgeting project generally considered separate from other capital budgeting projects. It is not necessarily compared to another project or projects to determine which is best. The acceptance of an independent project does not necessarily cause another project or projects to be rejected.

Interest rate   The return earned on an investment expressed as a percentage rate. Also the cost paid on a loan expressed as a percentage rate.

Internal rate of return   The interest rate at which a project's net present value equals zero. It is also the interest rate at which the sum of the present values of the net cash flows equals the net investment. It is essentially the annual percentage rate of return on a capital budgeting project.

Investment decision   A decision made by the firm regarding particular assets to invest in. Represents one of the three major financial decisions of the firm.

Issuance costs   Any costs a firm incurs to issue or float a new security. Includes investment banking and legal fees as well as any other relevant costs. Same as flotation costs.

back to top

Liquidity ratios   A class of ratios that measures the ability of a firm to cover its current obligations (liabilities).

back to top

Marginal cost of capital   This is the cost of raising new funds as opposed to the historical cost of funds. It is the cost of new funds that is relevant to new investments.

Market maker   An individual who helps make markets more efficient by being ready to buy or sell securities.

Market portfolio   A theoretical portfolio of all traded assets that is also the most efficient in terms of offering the most return for a given level of risk.

Market value   The most likely sales price negotiated between a buyer and seller under normal conditions.

Modified accelerated cost recovery system (MACRS) depreciation   The method prescribed for depreciation for tax purposes in the United States since 1986.

Modified internal rate of return   The interest rate at which the project's present value of investment costs equal the project's terminal value of net cash flows. An acceptable capital budgeting project has a modified internal rate of return greater than the required rate of return.

Mortgage bond   A collateralized bond. A bond backed by specific assets.

Mortgage-backed securities   Securities that offer income from the payment of principal and interest on mortgages or other loans.

Mutually exclusive project   A capital budgeting project that is considered relative to other alternative capital budgeting projects to determine which one is best and which one should be accepted, if any. The acceptance of a mutually exclusive project does directly cause another alternative project or alternative projects to be rejected.

back to top

Net cash flow   The cash flow created by a capital budgeting project during one year of the project's life. It is computed as the change in operating earnings after taxes plus the change in depreciation minus the change in net working capital during the year.

Net investment   The cost of starting a project or the net cash outflows required to ready a project for its basic function or operation; sometimes called the initial investment or initial outlay.

Net operating income (NOI)   The income available to the owners after fixed charges and a reserve for replacement, but before interest, income taxes, depreciation, and amortization.

Net present value   The sum of the present values of the net cash flows minus the net investment. It is the expected increase in the value of the firm due to an investment in a capital budgeting project.

Nominal annual interest rate   The interest rate as stated in a contract. The nominal interest rate does not take into account compounding. For example, $100 invested at a 6 percent nominal annual rate compounded monthly for one year does not earn $6.00 but will earn $6.17.

Normal capital budgeting project   A project with all positive net cash flows after the net investment. A normal project has one sign change with its cash flows; negative to positive as the negative cash flows from the net investment turn into positive cash flows from the net cash flows. A project that is not normal will have two or more sign changes in its cash flows.

back to top

Opportunity cost   The actual value a firm loses when it makes a decision. This may or may not be the same as the accounting cost. For example, if you give a diamond ring that you purchased 15 years ago to your daughter, your opportunity cost is not what you paid for the ring 15 years ago, and it is not the retail appraised value from your local jeweler. The opportunity cost is what you could have sold the ring for if you had not given it away, or the actual dollar value you are losing by making the decision to give it away.

Optimal capital structure   The capital structure that minimizes a firm's weighted average cost of capital and maximizes the value of the firm.

back to top

Par value on a bond   The principal amount of the bond that is paid at maturity in addition to any remaining coupon payments. Sometimes called the face value. Corporate bond par values are usually $1,000.

Par value on preferred stock   An arbitrary amount assigned to preferred stock by the issuing corporation. Preferred stock par value is usually $25, $50, or $100.

Payback period   The number of years it takes for a project's net cash flows to recover the net investment.

Perpetuity   An infinite series of uniform, future payments. In other words, it is an infinite annuity.

Preferred stock   A stock with a seniority claim superior to common stock but inferior to debt. Preferred stock dividends are usually a fixed quarterly payment.

Present value   Literally the value today of a future value. More generally as used in financial mathematics, it is the value at an earlier point in time of a single future cash amount or of several future cash amounts.

Primary market   The initial sale of common stock to an investment banker or group of bankers who will later issue the stock to the general public.

Principal   The original amount of money invested or borrowed. The interest rate return on an investment or the interest rate cost on a loan is computed as a percentage of the principal.

Probability distribution   A series of outcomes and associated probabilities with each outcome.

Profitability index   The sum of the present values of the net cash flows divided by the net investment. A profitability index greater than one indicates an acceptable capital budgeting project.

Put feature   A bond feature that allows the investor to demand that the corporation repay the bond prior to maturity.

back to top

Real estate   Land and all that is permanently affixed to the land.

Required rate of return   The minimum rate of return that will satisfy an investor.

Risk   Uncertainty about whether future outcomes will differ from our expectations.

Risk aversion   The concept whereby investors must be compensated for bearing risk.

Risk-free rate of return   The return received on a government instrument (i.e., bill, bond, or note) with an appropriate maturity for the asset involved.

back to top

Secondary market   The market that represents the bulk of stock and bond trading. This market represents trading between individuals.

Securities and Exchange Commission (SEC)   An agency of the federal government established in 1933 and responsible for the regulation of securities trading in the United States.

Seniority   Refers to the order in which a corporation would pay off its obligations in case of financial difficulty. A senior obligation is paid before an obligation lacking seniority.

Sinking fund on bonds   A bond feature requiring the issuing corporation to retire a portion of the bonds prior to maturity.

Sinking fund on preferred stock   A preferred stock feature requiring the issuing corporation to redeem a certain percentage of the total preferred stock each year.

Solvency ratios   A class of ratios that measure the extent of the use of debt financing by a firm.

Standard deviation   A measure of dispersion around an expected value of mean; the square root of the variance.

Statement of cash flows   Statement showing the sources and uses of cash over a period of time. The statement is divided into three major sections: operating activities, investing activities, and financing activities.

Statement of retained earnings   Statement showing changes in the retained earnings portion of the balance sheet over a period of time. Now, it is combined into a larger statement known as the Statement of Changes in Owner's Position.

Subordinated   Used to indicate seniority on a bond. A subordinated debenture will be paid after an unsubordinated debenture.

Sunk costs   Costs that have been paid in the past and are thus irrelevant because the cost has been paid whether a project is accepted or rejected.

Systematic risk   The component of total risk that is market related and cannot be eliminated in a diversified portfolio.

back to top

Target capital structure   The proportions of various capital components a firm plans to use to fund investments. Capital components may include permanent short-term debt, long-term debt, preferred stock, and common equity.

Tax carryback   The ability of a firm to use current losses as a way to offset earnings in prior years. The current limit is two years.

Tax carryforward   The ability of a firm to use current losses as a way to offset earnings in future years.

Terminal capitalization rate   A rate of return used to determine a gross sales price at the end of a holding period.

back to top

Uniform System of Accounts   Standardized income statement that allows for easier comparability between properties. Used for hotels, restaurants, and clubs.

Unsystematic risk   The component of total risk that is related to a specific business or industry that can be eliminated in a diversified portfolio.

back to top

Value creation   The outcome of an asset's prospective benefits exceeding its costs.

Variance   A measure of dispersion around an expected value, or mean.

back to top

Weighted average cost of capital   The weighted average of the costs of a firm's funds raised from debt, preferred stock, and common equity. The weights are generally equal to a firm's target capital structure.

back to top

Yield to maturity   The investor's rate of return on a security investment. The investor's rate of return on a bond held to maturity. The investor's rate of return on preferred stock if the preferred stock is not sold by the investor.

back to top

Zero coupon securities   Bonds that are bought at discount and gain value as they near maturity; no interest payments are made.

back to top