Capital Budgeting Terms By Category

 

Capital Budgeting Terms by Category

Understanding the Table

The following table categorizes key terms used in capital budgeting. Each term is briefly defined for clarity.

Table of Capital Budgeting Terms

Category	Term	Definition
Project Evaluation Techniques	Payback Period	The length of time required to recover the initial investment in a project.
	Accounting Rate of Return (ARR)	The average annual net income from a project divided by the average investment.
	Net Present Value (NPV)	The difference between the present value of cash inflows and the present value of cash outflows.
	Internal Rate of Return (IRR)	The discount rate that makes the NPV of a project equal to zero.
	Profitability Index (PI)	The ratio of the present value of cash inflows to the initial investment.
Cash Flow Analysis	Initial Investment	The total cash outflow required to start a project.
	Operating Cash Flow	The net cash generated from a project's normal operations.
	Terminal Cash Flow	The cash inflow or outflow at the end of a project's life.
	Incremental Cash Flow	The change in cash flow resulting from a project.
Risk and Uncertainty	Sensitivity Analysis	The process of examining how sensitive a project's NPV is to changes in key variables.
	Scenario Analysis	The process of evaluating a project under different possible scenarios.
	Risk-Adjusted Discount Rate	A discount rate that reflects the riskiness of a project.
Capital Budgeting Process	Capital Budgeting	The process of evaluating and selecting long-term investment projects.
	Capital Rationing	The situation where a company has limited funds to invest in available projects.
	Mutually Exclusive Projects	Projects where only one can be selected.
	Independent Projects	Projects that can be accepted or rejected independently of each other.

Project Evaluation Techniques

Overview

Project evaluation techniques are methods used to assess the financial viability of potential investments. They help determine whether a project is worth undertaking and provide a basis for comparison among different investment options.

Common Techniques

Technique	Description	Advantages	Disadvantages
Payback Period	The length of time required to recover the initial investment.	Easy to calculate and understand. Emphasizes liquidity.	Ignores cash flows after payback, ignores time value of money.
Accounting Rate of Return (ARR)	Average annual net income divided by average investment.	Simple to calculate, uses accounting data.	Ignores time value of money, based on accounting profits, not cash flows.
Net Present Value (NPV)	The difference between the present value of cash inflows and the present value of cash outflows.	Considers time value of money, directly measures profitability.	Requires accurate cash flow and discount rate estimates.
Internal Rate of Return (IRR)	The discount rate that makes the NPV of a project equal to zero.	Considers time value of money, provides a percentage return.	Can lead to multiple IRRs or no IRR in certain cases.
Profitability Index (PI)	The ratio of the present value of cash inflows to the initial investment.	Considers time value of money, useful for ranking projects under capital rationing.	Requires accurate cash flow and discount rate estimates.

Capital Budgeting Terms

Term	Definition
Capital Budgeting	Process of evaluating and selecting long-term investments
Project Evaluation Techniques	Methods to assess investment viability
* Payback Period	Time to recover initial investment
* Accounting Rate of Return (ARR)	Average annual net income / average investment
* Net Present Value (NPV)	PV of cash inflows - PV of cash outflows
* Internal Rate of Return (IRR)	Discount rate where NPV = 0
* Profitability Index (PI)	PV of cash inflows / initial investment
Cash Flow Analysis	Evaluation of cash inflows and outflows
* Initial Investment	Cash outflow to start a project
* Operating Cash Flow	Net cash from normal operations
* Terminal Cash Flow	Cash flow at project end
* Incremental Cash Flow	Change in cash flow due to project
Risk and Uncertainty	Factors affecting project outcomes
* Sensitivity Analysis	How NPV changes with variable changes
* Scenario Analysis	Evaluating project under different scenarios
* Risk-Adjusted Discount Rate	Higher discount rate for riskier projects
Capital Budgeting Process	Steps involved in investment decisions
* Capital Rationing	Limited funds for available projects
* Mutually Exclusive Projects	Only one can be selected
* Independent Projects	Can be accepted or rejected separately
Additional Terms	Other relevant concepts
* Discount Rate	Interest rate used to calculate present value
* Weighted Average Cost of Capital (WACC)	Average cost of financing
* Sunk Cost	Irrecoverable cost
* Opportunity Cost	Value of best alternative forgone
* Cannibalization	New product reduces sales of existing product

Additional Capital Budgeting Terms

Term	Definition
Replacement Project	Investing in a new asset to replace an old one
Expansion Project	Investing in new assets to increase capacity or market share
Diversification Project	Investing in new products or markets
Research and Development Project	Investing in developing new products or processes
Post-Audit	Evaluating the performance of a completed project
Real Options	Flexibility to modify a project based on future events
Inflation	The general increase in prices over time, affecting cash flows
Taxes	Government levies impacting project cash flows
Depreciation	Allocating the cost of an asset over its useful life
Working Capital	Current assets minus current liabilities

Additional Capital Budgeting Terms

Term	Definition
Replacement Project	Investing in a new asset to replace an old one
Expansion Project	Investing in new assets to increase capacity or market share
Diversification Project	Investing in new products or markets
Research and Development (R&D) Project	Investing in developing new products or processes
Post-Audit	Evaluating the performance of a completed project
Real Options	Flexibility to modify a project based on future events
Inflation	The general increase in prices over time, affecting cash flows
Taxes	Government levies impacting project cash flows
Depreciation	Allocating the cost of an asset over its useful life
Working Capital	Current assets minus current liabilities
Equivalent Annual Annuity (EAA)	Converts uneven cash flows into equal annual cash flows for comparison
Capital Asset Pricing Model (CAPM)	Used to estimate the required rate of return for a project
Beta	Measures a stock's volatility relative to the market
Unsystematic Risk	Risk specific to a company
Systematic Risk	Market risk that cannot be diversified away
Cost of Capital	The average cost of financing a company's assets

Additional Capital Budgeting Terms

Term	Definition
Replacement Project	Investing in a new asset to replace an old one
Expansion Project	Investing in new assets to increase capacity or market share
Diversification Project	Investing in new products or markets
Research and Development (R&D) Project	Investing in developing new products or processes
Post-Audit	Evaluating the performance of a completed project
Real Options	Flexibility to modify a project based on future events
Inflation	The general increase in prices over time, affecting cash flows
Taxes	Government levies impacting project cash flows
Depreciation	Allocating the cost of an asset over its useful life
Working Capital	Current assets minus current liabilities
Equivalent Annual Annuity (EAA)	Converts uneven cash flows into equal annual cash flows for comparison
Capital Asset Pricing Model (CAPM)	Used to estimate the required rate of return for a project
Beta	Measures a stock's volatility relative to the market
Unsystematic Risk	Risk specific to a company
Systematic Risk	Market risk that cannot be diversified away
Cost of Capital	The average cost of financing a company's assets
Marginal Cost of Capital (MCC)	The cost of raising additional capital
Capital Structure	The mix of debt and equity financing
Financial Leverage	The use of debt to amplify returns
Break-Even Analysis	Determining the sales volume needed to cover costs
Sensitivity Analysis	Analyzing how changes in variables affect project outcomes
Scenario Analysis	Evaluating project performance under different scenarios
Monte Carlo Simulation	Using probability distributions to estimate project outcomes

Additional Capital Budgeting Terms

Term	Definition
Replacement Project	Investing in a new asset to replace an old one
Expansion Project	Investing in new assets to increase capacity or market share
Diversification Project	Investing in new products or markets
Research and Development (R&D) Project	Investing in developing new products or processes
Post-Audit	Evaluating the performance of a completed project
Real Options	Flexibility to modify a project based on future events
Inflation	The general increase in prices over time, affecting cash flows
Taxes	Government levies impacting project cash flows
Depreciation	Allocating the cost of an asset over its useful life
Working Capital	Current assets minus current liabilities
Equivalent Annual Annuity (EAA)	Converts uneven cash flows into equal annual cash flows for comparison
Capital Asset Pricing Model (CAPM)	Used to estimate the required rate of return for a project
Beta	Measures a stock's volatility relative to the market
Unsystematic Risk	Risk specific to a company
Systematic Risk	Market risk that cannot be diversified away
Cost of Capital	The average cost of financing a company's assets
Marginal Cost of Capital (MCC)	The cost of raising additional capital
Capital Structure	The mix of debt and equity financing
Financial Leverage	The use of debt to amplify returns
Break-Even Analysis	Determining the sales volume needed to cover costs
Sensitivity Analysis	Analyzing how changes in variables affect project outcomes
Scenario Analysis	Evaluating project performance under different scenarios
Monte Carlo Simulation	Using probability distributions to estimate project outcomes
Decision Tree Analysis	A graphical representation of alternative decisions and their possible outcomes
Opportunity Cost of Capital	The return on the best alternative investment
Discounted Payback Period	Time to recover initial investment considering time value of money
Modified Internal Rate of Return (MIRR)	Addresses IRR limitations by assuming reinvestment at the cost of capital

Additional Capital Budgeting Terms

Term	Definition
Replacement Project	Investing in a new asset to replace an old one
Expansion Project	Investing in new assets to increase capacity or market share
Diversification Project	Investing in new products or markets
Research and Development (R&D) Project	Investing in developing new products or processes
Post-Audit	Evaluating the performance of a completed project
Real Options	Flexibility to modify a project based on future events
Inflation	The general increase in prices over time, affecting cash flows
Taxes	Government levies impacting project cash flows
Depreciation	Allocating the cost of an asset over its useful life
Working Capital	Current assets minus current liabilities
Equivalent Annual Annuity (EAA)	Converts uneven cash flows into equal annual cash flows for comparison
Capital Asset Pricing Model (CAPM)	Used to estimate the required rate of return for a project
Beta	Measures a stock's volatility relative to the market
Unsystematic Risk	Risk specific to a company
Systematic Risk	Market risk that cannot be diversified away
Cost of Capital	The average cost of financing a company's assets
Marginal Cost of Capital (MCC)	The cost of raising additional capital
Capital Structure	The mix of debt and equity financing
Financial Leverage	The use of debt to amplify returns
Break-Even Analysis	Determining the sales volume needed to cover costs
Sensitivity Analysis	Analyzing how changes in variables affect project outcomes
Scenario Analysis	Evaluating project performance under different scenarios
Monte Carlo Simulation	Using probability distributions to estimate project outcomes
Decision Tree Analysis	A graphical representation of alternative decisions and their possible outcomes
Opportunity Cost of Capital	The return on the best alternative investment
Discounted Payback Period	Time to recover initial investment considering time value of money
Modified Internal Rate of Return (MIRR)	Addresses IRR limitations by assuming reinvestment at the cost of capital
Risk Premium	The excess return required by investors for taking on additional risk
Certainty Equivalent	The certain cash flow equivalent to a risky cash flow
Erosion	The negative impact of a new project on existing cash flows
Abandonment Value	The potential salvage value of a project

Additional Capital Budgeting Terms

Term	Definition
Replacement Project	Investing in a new asset to replace an old one
Expansion Project	Investing in new assets to increase capacity or market share
Diversification Project	Investing in new products or markets
Research and Development (R&D) Project	Investing in developing new products or processes
Post-Audit	Evaluating the performance of a completed project
Real Options	Flexibility to modify a project based on future events
Inflation	The general increase in prices over time, affecting cash flows
Taxes	Government levies impacting project cash flows
Depreciation	Allocating the cost of an asset over its useful life
Working Capital	Current assets minus current liabilities
Equivalent Annual Annuity (EAA)	Converts uneven cash flows into equal annual cash flows for comparison
Capital Asset Pricing Model (CAPM)	Used to estimate the required rate of return for a project
Beta	Measures a stock's volatility relative to the market
Unsystematic Risk	Risk specific to a company
Systematic Risk	Market risk that cannot be diversified away
Cost of Capital	The average cost of financing a company's assets
Marginal Cost of Capital (MCC)	The cost of raising additional capital
Capital Structure	The mix of debt and equity financing
Financial Leverage	The use of debt to amplify returns
Break-Even Analysis	Determining the sales volume needed to cover costs
Sensitivity Analysis	Analyzing how changes in variables affect project outcomes
Scenario Analysis	Evaluating project performance under different scenarios
Monte Carlo Simulation	Using probability distributions to estimate project outcomes
Decision Tree Analysis	A graphical representation of alternative decisions and their possible outcomes
Opportunity Cost of Capital	The return on the best alternative investment
Discounted Payback Period	Time to recover initial investment considering time value of money
Modified Internal Rate of Return (MIRR)	Addresses IRR limitations by assuming reinvestment at the cost of capital
Risk Premium	The excess return required by investors for taking on additional risk
Certainty Equivalent	The certain cash flow equivalent to a risky cash flow
Erosion	The negative impact of a new project on existing cash flows
Abandonment Value	The potential salvage value of a project
Mutually Exclusive Projects	Projects where only one can be selected
Independent Projects	Projects that can be accepted or rejected independently
Capital Rationing	Limited funds available for investment
Incremental Cash Flows	Cash flows directly attributable to a project
Sunk Costs	Costs already incurred and cannot be recovered
Opportunity Costs	The value of the next best alternative foregone
Cannibalization	When a new product reduces sales of an existing product

Additional Capital Budgeting Terms

Term	Definition
Replacement Project	Investing in a new asset to replace an old one
Expansion Project	Investing in new assets to increase capacity or market share
Diversification Project	Investing in new products or markets
Research and Development (R&D) Project	Investing in developing new products or processes
Post-Audit	Evaluating the performance of a completed project
Real Options	Flexibility to modify a project based on future events
Inflation	The general increase in prices over time, affecting cash flows
Taxes	Government levies impacting project cash flows
Depreciation	Allocating the cost of an asset over its useful life
Working Capital	Current assets minus current liabilities
Equivalent Annual Annuity (EAA)	Converts uneven cash flows into equal annual cash flows for comparison
Capital Asset Pricing Model (CAPM)	Used to estimate the required rate of return for a project
Beta	Measures a stock's volatility relative to the market
Unsystematic Risk	Risk specific to a company
Systematic Risk	Market risk that cannot be diversified away
Cost of Capital	The average cost of financing a company's assets
Marginal Cost of Capital (MCC)	The cost of raising additional capital
Capital Structure	The mix of debt and equity financing
Financial Leverage	The use of debt to amplify returns
Break-Even Analysis	Determining the sales volume needed to cover costs
Sensitivity Analysis	Analyzing how changes in variables affect project outcomes
Scenario Analysis	Evaluating project performance under different scenarios
Monte Carlo Simulation	Using probability distributions to estimate project outcomes
Decision Tree Analysis	A graphical representation of alternative decisions and their possible outcomes
Opportunity Cost of Capital	The return on the best alternative investment
Discounted Payback Period	Time to recover initial investment considering time value of money
Modified Internal Rate of Return (MIRR)	Addresses IRR limitations by assuming reinvestment at the cost of capital
Risk Premium	The excess return required by investors for taking on additional risk
Certainty Equivalent	The certain cash flow equivalent to a risky cash flow
Erosion	The negative impact of a new project on existing cash flows
Abandonment Value	The potential salvage value of a project
Mutually Exclusive Projects	Projects where only one can be selected
Independent Projects	Projects that can be accepted or rejected independently
Capital Rationing	Limited funds available for investment
Incremental Cash Flows	Cash flows directly attributable to a project
Sunk Costs	Costs already incurred and cannot be recovered
Opportunity Costs	The value of the next best alternative foregone
Cannibalization	When a new product reduces sales of an existing product
Operating Leverage	The extent to which fixed costs are used in a company's operations
Financial Leverage	The use of debt to amplify returns
Combined Leverage	The combined effect of operating and financial leverage
Degree of Operating Leverage (DOL)	Measures the sensitivity of operating income to changes in sales
Degree of Financial Leverage (DFL)	Measures the sensitivity of earnings per share to changes in operating income
Degree of Combined Leverage (DCL)	Measures the sensitivity of earnings per share to changes in sales