Managing Financial Risk

Income Statement: A report of a firm’s activities during a given accounting period,
normally one year. The Income Statement is also called the profit and loss statement or
the statement of earnings.

Indifference Curve: The graphic representation of the trade-offs in value between risk
and return.

Inefficient Markets: Within investment markets, an inefficient market exists when the
required return is not equal to the likely return from the investment.

Intermediate-term financing: Borrowings with maturities greater than one year but less
than five to seven years.

Intrinsic Value: The real worth of a security (or asset) when all of the primary factors
that create value are taken into consideration.

Leverage: In the financial risk management context, leverage is the use of debt to
enhance profits and cash flow.

LIBOR (London Interbank Offered Rate): A money market indicator commonly used
outside of the United States.

Likely Return: A forecast of the probable or expected return from an investment.

Marginal Contribution: Defined as the excess of sales over variable costs. Stated
differently, it is the direct profit from operations.

Market Line: In the financial risk management context, can be defined as the general
pattern of risk and return in an investing market.

Net Present Value: The difference between the present value of the net cash benefits
and the present value of the net cash outlay of an investment activity.

Net Working Capital: Equals the difference between current assets and current
liabilities. It is used as a measure of liquidity.

Nonlinear Breakeven Analysis: With nonlinear breakeven analysis, a firm strives for an
optimum output level within a range of efficient production activities.

Normal Price-Earnings Multiple: A normal price-earnings multiple is the ratio that is
expected when a firm is realizing a satisfactory return on its capital, and the stock market
is not disturbed by unusual psychological or economic factors.

Payback Period: The length of time needed to regain the original cash outlay for an
investment proposal.

Price-earnings Ratio: Calculated by dividing the market price of a common stock by its
earnings per share.

Profit Margin: The percent of profit earned on a company’s revenues.

Glossary G-3

Pure Risk: The chance of an unexpected or unplanned loss without the accompanying
chance of a gain. Also may be called insurable risk.

Required Return: The determination of whether the likely return is satisfactory, given
the level of risk in an investment.

Return on Equity (ROE): An important profit indicator to shareholders of a firm. It is
calculated by dividing net income over total equity.

Risk: In the financial context, it is defined as the likelihood that the actual return from an
investment will be less than the expected return.

Standard Deviation: A measure of the dispersion of returns in a normal probability
distribution. Six standard deviations make up virtually the entire range of possible
statistical outcomes from an investment.

Synergism: The concept that some business entity combinations have a total greater
than the sum of the parts originally derived from each alone.

Tax Shield: Defined as a non-cash expense that reduces the level of taxes paid by a
firm.

Trial Balance: A list of the current summarized values of all accounting transactions in a
period.

Working Capital Pool: A key cash flow concept; which consists of all the current
accounts of the firm.

Glossary G-4

Index

A I

accelerated depreciation, 10-5 indifference curves, 9-10, 9-11
amortization, 8-5, 8-7, 8-8, 8-14, 10-8, intrinsic value, 12-3, 12-4, 12-5, 12-6,

10-9, 10-10, 10-16, 11-4, 11-21, 12-7, 12-8, 12-9, 12-10, 12-11,
14-13, 14-15, 14-19 12-12, 12-13, 12-14, 12-16, 12-17,
14-8
B IRR method, 11-6

breakeven analysis, 5-1, 5-3, 5-4, 5-5 L

C Lehman Brothers, 2-7
leverage, 1-12, 6-1, 6-3, 6-4, 6-5, 6-6,
capital asset pricing model, 9-1, 9-14,
13-5, 13-12, 13-13 6-7, 6-8, 6-9, 6-10, 6-11, 6-12, 6-13,
6-14, 6-15, 6-16, 6-17, 6-18, 13-8,
capital structure, 1-8, 1-13, 6-9, 7-10, 13-9, 13-10, 13-11, 13-12, 13-13,
7-11, 7-12, 7-13, 13-1, 13-2, 13-3, 13-14, 13-15, 14-3, 14-4, 14-5, 14-6,
13-4, 13-8, 13-9, 13-10, 13-12, 14-8
13-13, 13-14, 13-15, 13-18 liquidation value, 7-12, 12-3, 12-17

capitalized costs, 10-7, 10-8, 10-9, M
10-10, 10-15, 10-16, 11-12, 11-13,
11-14, 11-20, 11-21 marginal analysis, 5-1, 5-7, 5-8
marketing risk, 1-5, 1-6
comparative ratios, 7-3, 7-7, 7-14 Miller and Modigliani, 9-1, 13-9, 13-11,

D 13-12, 13-15

debt-asset ratio, 7-10, 7-11, 7-12, 7-13, N
7-17
New York Stock Exchange, 12-2
debt-equity ratio, 7-10, 7-11, 7-12, 7-13, NPV method, 11-5, 11-6
7-17, 13-8, 13-9, 14-8
P
diversification, 10-2, 11-5, 14-2, 14-3
payback method, 11-1, 11-2
E perpetuity, 12-6
preferred stock, 2-4, 12-1, 12-3, 13-2,
enterprise risk, 1-1, 1-3, 1-12, 4-1, 6-12
Ericsson, Nokia, and Phillips, 1-4, 1-5 13-3, 14-11
present values, 10-9, 10-15, 11-2, 11-3,
G
11-6, 11-11, 11-12, 11-14, 11-20,
Gordon model, 12-7, 12-8, 12-9, 12-12, 12-6, 12-11
12-13, 12-16 pro forma financial statements, 2-10
profit margin, 4-13, 6-1, 6-2, 6-3, 6-4,
6-5, 6-6, 6-13, 7-8, 7-9, 7-16, 7-19,
7-20, 13-5, 14-6, 14-10
profit-volume analysis, 5-1, 5-3, 5-6, 5-7,
5-19
pyramiding, 14-3, 14-4

Index 1

R

ratio analysis, 7-1, 7-5, 7-18, 7-20, 12-5

S

standard deviation, 9-4, 9-5, 9-6, 9-7,
9-8, 9-12, 9-13, 9-16, 9-17, 9-18,
10-5, 10-11

stock dividend, 3-7, 12-2
straight-line depreciation, 10-5, 10-11,

11-18

V

valuation concepts, 12-3
venture capitalists, 10-14

W

weighted average model, 13-3, 13-4,
13-5

working capital pool, 3-1, 3-2, 3-18, 3-19

Index 2