Financial Terms and Concepts

1) IRR: the Internal Rate of Return. The IRR is the discount rate that equates the present value of the future cash flows to the initial investment. More generically, the IRR is the discount rate that makes the sum of the present values of the cash flows zero when the investments are considered negative cash flows. The Internal Rate of Return on a bond is the yield to maturity.

2) Free cash flow (FCF): is the cash flow that a business generates and is available for distribution to debt holders and equity holders. It consists of the cash flow thrown off by operations minus the use of funds from the growth in its net working capital and from its capital expenditures required to maintain the firm's growth. It is commonly approximated by:

free cash flow = EBIT plus depreciation expense minus income taxes
minus the change in net working capital minus capital expenditures

This definition has the advantage that an external analysts can find the data on published financial statements. However, it has two disadvantages:

• It does not adjust for other accruals which may be distorting EBIT.
• The proper measure of FCF would use the required growth in net working capital and the required capital expenditures not the actual amounts. These requirements, of course, are not published. An analyst might estimate the firm's growth requirements and substitute his own estimates for the published actuals.

3) Operating Leverage: a firm's dependence on fixed costs rather than variabble costs. The greater a firm's operating leverage, the greater its business risk: i.e., the greater the impact of fluctuating demand or cost shocks on its profitability.