Finance

Mutually exclusive

A situation in which taking one investment prevents the taking of another. If two investments, X and Y, are mutually exclusive, then taking one of them means that we can not take the other- they are independent.

Pro forma financial statement

Financial statements projecting future years' operations. They are a convenient and easily understood means of summarizing much of the relevant information for a project. Needed are estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit and total fixed costs. Also need the total investment required, including the investment in net working capital.

Payback

The amount of time required for an investment to generate cash flows sufficient enough to recover initial cost. Based on the payback rule, an investment is acceptable if its calculated payback period is less than some pre specified number of years.

Stand-alone principle

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

Erosion

The cash flows of a new project that come at the expense of a firm's existing projects.

Incremental cash flow

The difference between a firm's future cash flows with a project and those without the project. The incremental cash flows project evaluation consists of any and all changes in the firm's future cash flows that are a direct consequence of taking the project. Any cash flow that exists regardless of whether or not a project is undertaken is not relevant

Net Present Value

The difference between an investment's market value and cost. A measure of how much value is created or added today by undertaking an investment.

Internal Rate of Return

The discount rate that makes the NPV of an investment zero. With the IRR, we try to find a single rate of return that summarizes the merits of a project. Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

Salvage value

The estimated value that an asset will realize upon its sale at the end of its useful life.

Discounted Payback

The length of time required for an investment's discounted cash flows to equal its initial investment. Based on the discount payback rule, an investment is acceptable if its discounted payback is less than some pre specified number of years

Opportunity cost

The most valuable alternative that is given up if a particular investment is undertaken. It requires us to give up benefit.

Equivalent annual cost

The present value of a project's costs calculated on an annual basis.

Profitability index

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

Discounted Cash Flow Evaluation

The process of valuing an investment by discounting its future cash flows. Estimate NPV as the difference between the value of the future cash flows and the cost of the investment. An investment should be accepted if the net present value is positive and rejected if it is negative.

Depreciation tax shield

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

Mutually exclusive project

are a set of projects from which at most one will be accepted. For example, a set of projects, which are to accomplish the same task. Thus, when choosing between "Mutually Exclusive Projects" more than one project may satisfy the Capital Budgeting criterion. However, only one, i.e., the best project can be accepted.

Sunk cost

A cost that has already been incurred and cannot be removed and therefore, should not be considered an investment.

Concept of erosion

A negative impact on the cash flows of an existing product from the introduction of a new product is called erosion. In this case, the cash flows from the newline should be adjusted downward to reflect the lost profits on other lines. In accounting for erosion, it is important to recognize that any sales lost as a result of launching a new product might be lost anyway because of future competition. Erosion is relevant only when the sakes would not otherwise be lost.