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.
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.
| 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
| 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 |