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

CategoryTermDefinition
Project Evaluation TechniquesPayback PeriodThe 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 AnalysisInitial InvestmentThe total cash outflow required to start a project.
Operating Cash FlowThe net cash generated from a project's normal operations.
Terminal Cash FlowThe cash inflow or outflow at the end of a project's life.
Incremental Cash FlowThe change in cash flow resulting from a project.
Risk and UncertaintySensitivity AnalysisThe process of examining how sensitive a project's NPV is to changes in key variables.
Scenario AnalysisThe process of evaluating a project under different possible scenarios.
Risk-Adjusted Discount RateA discount rate that reflects the riskiness of a project.
Capital Budgeting ProcessCapital BudgetingThe process of evaluating and selecting long-term investment projects.
Capital RationingThe situation where a company has limited funds to invest in available projects.
Mutually Exclusive ProjectsProjects where only one can be selected.
Independent ProjectsProjects 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

TechniqueDescriptionAdvantagesDisadvantages
Payback PeriodThe 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

TermDefinition
Capital BudgetingProcess of evaluating and selecting long-term investments
Project Evaluation TechniquesMethods to assess investment viability
* Payback PeriodTime 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 AnalysisEvaluation of cash inflows and outflows
* Initial InvestmentCash outflow to start a project
* Operating Cash FlowNet cash from normal operations
* Terminal Cash FlowCash flow at project end
* Incremental Cash FlowChange in cash flow due to project
Risk and UncertaintyFactors affecting project outcomes
* Sensitivity AnalysisHow NPV changes with variable changes
* Scenario AnalysisEvaluating project under different scenarios
* Risk-Adjusted Discount RateHigher discount rate for riskier projects
Capital Budgeting ProcessSteps involved in investment decisions
* Capital RationingLimited funds for available projects
* Mutually Exclusive ProjectsOnly one can be selected
* Independent ProjectsCan be accepted or rejected separately
Additional TermsOther relevant concepts
* Discount RateInterest rate used to calculate present value
* Weighted Average Cost of Capital (WACC)Average cost of financing
* Sunk CostIrrecoverable cost
* Opportunity CostValue of best alternative forgone
* CannibalizationNew product reduces sales of existing product

Additional Capital Budgeting Terms

TermDefinition
Replacement ProjectInvesting in a new asset to replace an old one
Expansion ProjectInvesting in new assets to increase capacity or market share
Diversification ProjectInvesting in new products or markets
Research and Development ProjectInvesting in developing new products or processes
Post-AuditEvaluating the performance of a completed project
Real OptionsFlexibility to modify a project based on future events
InflationThe general increase in prices over time, affecting cash flows
TaxesGovernment levies impacting project cash flows
DepreciationAllocating the cost of an asset over its useful life
Working CapitalCurrent assets minus current liabilities

Additional Capital Budgeting Terms

TermDefinition
Replacement ProjectInvesting in a new asset to replace an old one
Expansion ProjectInvesting in new assets to increase capacity or market share
Diversification ProjectInvesting in new products or markets
Research and Development (R&D) ProjectInvesting in developing new products or processes
Post-AuditEvaluating the performance of a completed project
Real OptionsFlexibility to modify a project based on future events
InflationThe general increase in prices over time, affecting cash flows
TaxesGovernment levies impacting project cash flows
DepreciationAllocating the cost of an asset over its useful life
Working CapitalCurrent 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
BetaMeasures a stock's volatility relative to the market
Unsystematic RiskRisk specific to a company
Systematic RiskMarket risk that cannot be diversified away
Cost of CapitalThe average cost of financing a company's assets

Additional Capital Budgeting Terms

TermDefinition
Replacement ProjectInvesting in a new asset to replace an old one
Expansion ProjectInvesting in new assets to increase capacity or market share
Diversification ProjectInvesting in new products or markets
Research and Development (R&D) ProjectInvesting in developing new products or processes
Post-AuditEvaluating the performance of a completed project
Real OptionsFlexibility to modify a project based on future events
InflationThe general increase in prices over time, affecting cash flows
TaxesGovernment levies impacting project cash flows
DepreciationAllocating the cost of an asset over its useful life
Working CapitalCurrent 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
BetaMeasures a stock's volatility relative to the market
Unsystematic RiskRisk specific to a company
Systematic RiskMarket risk that cannot be diversified away
Cost of CapitalThe average cost of financing a company's assets
Marginal Cost of Capital (MCC)The cost of raising additional capital
Capital StructureThe mix of debt and equity financing
Financial LeverageThe use of debt to amplify returns
Break-Even AnalysisDetermining the sales volume needed to cover costs
Sensitivity AnalysisAnalyzing how changes in variables affect project outcomes
Scenario AnalysisEvaluating project performance under different scenarios
Monte Carlo SimulationUsing probability distributions to estimate project outcomes

Additional Capital Budgeting Terms

TermDefinition
Replacement ProjectInvesting in a new asset to replace an old one
Expansion ProjectInvesting in new assets to increase capacity or market share
Diversification ProjectInvesting in new products or markets
Research and Development (R&D) ProjectInvesting in developing new products or processes
Post-AuditEvaluating the performance of a completed project
Real OptionsFlexibility to modify a project based on future events
InflationThe general increase in prices over time, affecting cash flows
TaxesGovernment levies impacting project cash flows
DepreciationAllocating the cost of an asset over its useful life
Working CapitalCurrent 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
BetaMeasures a stock's volatility relative to the market
Unsystematic RiskRisk specific to a company
Systematic RiskMarket risk that cannot be diversified away
Cost of CapitalThe average cost of financing a company's assets
Marginal Cost of Capital (MCC)The cost of raising additional capital
Capital StructureThe mix of debt and equity financing
Financial LeverageThe use of debt to amplify returns
Break-Even AnalysisDetermining the sales volume needed to cover costs
Sensitivity AnalysisAnalyzing how changes in variables affect project outcomes
Scenario AnalysisEvaluating project performance under different scenarios
Monte Carlo SimulationUsing probability distributions to estimate project outcomes
Decision Tree AnalysisA graphical representation of alternative decisions and their possible outcomes
Opportunity Cost of CapitalThe return on the best alternative investment
Discounted Payback PeriodTime 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

TermDefinition
Replacement ProjectInvesting in a new asset to replace an old one
Expansion ProjectInvesting in new assets to increase capacity or market share
Diversification ProjectInvesting in new products or markets
Research and Development (R&D) ProjectInvesting in developing new products or processes
Post-AuditEvaluating the performance of a completed project
Real OptionsFlexibility to modify a project based on future events
InflationThe general increase in prices over time, affecting cash flows
TaxesGovernment levies impacting project cash flows
DepreciationAllocating the cost of an asset over its useful life
Working CapitalCurrent 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