Finance Chapter 8 & 9

sunk cost

A cost that has already been incurred and cannot be recouped and therefore should not be considered in an investment decision.

Average Accounting Return

An investment's average net income divided by its average book value. some measure of average accounting profit divided by some measure of average accounting value.

Accelerated Cost Recovery System (ACRS)

Depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications.

Operating Cash Flow

EBIT + Depreciation - Taxes

the option to

Expand Abandon Wait

pro forma financial statements

Financial statements projecting future years' operations.

Sensitivity Analysis

Investigation of what happens to net present value when only one variable is changed.

discounted cash flow (DCF) valuation

(a) Calculating the present value of a future cash flow to determine its value today. (b) The process of valuing an investment by discounting its future cash flows.

Advantages of Profitability Index

-Closely related to NPV, generally leading to identical decisions -Easy to understand and communicate -May be useful when available investment funds are limited

Disadvantages of payback period

-Ignores the time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff date -Biased against long-term projects, such as research and development, and new projects

disadvantages of average accounting return

-Not a true rate of return; time value of money is ignored -Uses an arbitrary benchmark cutoff rate -Based on accounting net income and book values, not cash flows and market values

Advantages of Average Accounting Return

1. Easy to calculate 2. Needed information will usually be available

disadvantages of profitability index

May lead to incorrect decisions in comparisons of mutually exclusive investments

managerial options

Opportunities that managers can exploit if certain things happen in the future. Also known as "real" options.

contingency planning

Taking into account the managerial options implicit in a project.

Payback Period

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost. An investment is acceptable if its calculated payback period is less than some prespecified number of years.,

stand-alone principle

The assumption that evaluation of a project may be based on the project's incremental cash flows.

Scenario Analysis

The determination of what happens to net present value estimates when we ask what-if questions.

incremental cash flows

The difference between a firm's future cash flows with a project and those without the project. Consist of any and all changes in the firm's future cash flows that are a direct consequence of taking the project.

opportunity cost

The most valuable alternative that is given up if a particular investment is undertaken.

Capital Rationing

The situation that exists if a firm has positive net present value projects but cannot obtain the necessary financing.

depreciation tax shield

The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.

net present value profile

a graphical representation of the relationship between an investment's NPVs and various discount rates

Total Cash Flow

operating cash flow - change in NWC - capital spending

Project Cash Flow

project operating cash flow - project change in net working capital - project capital spending

An investment should be accepted if the net present value is positive and...

rejected if it's negative

Net Present Value

the difference between an investment's market value and its cost

Internal Rate of Return

the discount rate that makes the NPV of an investment zero

forecasting risk

the possibility that errors in projected cash flows will lead to incorrect decisions, also called estimation risk.

multiple rates of return

the possibility that more than one discount rate will make the NPV of an investment zero

Profitability Index

the present value of an investment's future cash flows divided by its initial cost, also called benefit-cost ratio

hard rationing

the situation that occurs when a business cannot raise financing for a project under any circumstances

soft rationing

the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting

Advantages of Payback Period

-easy to understand -adjusts for uncertainty of later cash flows -biased toward liquidity