Financial Markets and Instruments

Net working capital is defined as current assets minus current liabilities. It represents the portion of current assets financed by long-term sources.

Cash management involves balancing the opportunity cost of holding idle cash against the risk of liquidity shortages.

Keeping a large balance of cash is inefficient because it loses potential investment returns. Firms should maintain an optimal, not large, balance.

A high break-even point implies high fixed costs, which is the definition of high operating leverage.

Operating leverage relates to fixed operating costs, while financial leverage relates to fixed financial charges (like interest).

High operating leverage means a high proportion of fixed costs, which magnifies the impact of sales fluctuations on operating profit.

The MM approach assumes a perfect capital market where a single discount rate (the cost of capital) is appropriate for discounting future cash flows, assuming equivalent risk profiles.

Shareholder preference for dividends versus capital gains is a matter of debate (e.g., Bird-in-the-hand theory vs. Tax preference theory), so it is not a universal truth that they prefer one over the other.

IRR and NPV are distinct capital budgeting metrics. NPV measures absolute value in currency, while IRR measures the percentage rate of return.

Because future cash flows are uncertain, financial analysts use probability distributions and expected values to estimate them.

The Internal Rate of Return (IRR) represents the break-even interest rate. If a firm borrows at a rate lower than the IRR, the project is profitable; thus, it defines the maximum affordable cost of capital.

The payback period method focuses exclusively on the time required to recover the initial investment. It ignores all cash flows occurring after that point, which is a major limitation of the method.

Retained earnings are profits kept by a company from previous years. A new company has no history of earnings to retain, so it cannot rely on this source for initial financing.

Discounted cash flow (DCF) techniques, such as Net Present Value (NPV) and IRR, use discount rates to adjust future cash flows to their present value, explicitly accounting for the time value of money.