Chapter 12

capital budgeting

a process of identifying, evaluating, selecting, and controlling an organization's capital investments (ex: its long-term projects and programs)

capital investment

a project that involves a large up-front expenditure of funds and expected future benefits over a number of years

mutually exclusive projects

an extreme form of project interdependence: the acceptance of one investment alternative precludes the acceptance of one of more other alternatives

discount rate

a generic term that refers to the rate used in capital budgeting for converting estimated future cash flows to a present-value basis

capital budget

a listing of approved investment projects as well as anticipated cash inflows and outflows associated with these projects for a given period

non-DCF models

capital budgeting decision models that are not based on an analysis of the present value of future cash flows

discounted cash flow (DCF) models

capital budgeting decision models that incorporate the present value of future after-tax cash flows

capital budgetin focus

1. (after-tax) cash flows 2. the timing of these cash flows

yield to maturity

a long-term bond yield (rate of return) expressed as an annual rate; the calculation takes into account the current market price of the bond, its par value, the coupon interest rate, and the time to maturity; a rate of return that indicates the total performance of a bond, coupon payments as well as capital gain or loss, from the time of purchase until maturity

Beta coefficient

a measure of the sensitivity of a given stock's return to fluctuations in the overall market; the average beta of all stocks is 1.0; a beta coefficient greater than 1 implies greater sensitivity to market fluctuations, while a beta less than 1 implies lower sensitivity of return to fluctuations

multicriteria decision model

a model that includes more than one decision criterion

analytic hierarchy process (AHP)

a multicriteria decision technique that can combine qualitative and quantitative factors in the overall evaluation of decision alternatives

accounting (book) rate of return (ARR)

a rate of return on a project measured as the ratio of some measure of accounting profit associated with the project to some measure of investment in the project

weighted-average cost of capital (WACC)

an average of the (after-tax) cost of debt and equity capital for a firm; in general, the WACC is the appropriate discount rate to use for future cash flows associated with "average risk" projects

internal rate of return (IRR)

an estimate of the true (economic) rate of return on a proposed investment

Monte Carlo simulation (MCS)

an extension to scenario analysis I which a computer provides a distribution of possible outcomes - for example, project NPVs - based on repeated sampling from a distribution associated with one or more input variables in a decision model

post-audit

an in-depth review of a completed capital investment project for the purpose of comparing its realized costs and benefits (both financial and non financial) with the preinvestment estimates of these items

net working capital

as used within the context of capital budgeting, current assets other than cash (CA - cash) less current liabilities (CL)

real options

flexibilities and/or growth opportunities embedded in capital investment projects; can be contrasted with financial options, which are traded on an organized exchange

present value (PV)

future cash flows expressed in terms of current purchasing power; also referred to as time-adjusted value or current equivalent value

real assets

investment in both tangible property (ex: manufacturing facility) and intangible property (ex: a new information system)

capital asset pricing model (CAPM)

model that depicts the risk-return relationship for equity securities and that can be used to estimate the required rate of return on equity for a given company; a rate equal to the risk-free rate of return plus a risk premium measured as the product of Beta and the market-risk premium

average-risk projects

projects that approximate the risk of the firm's existing assets and operations; the WACC (weighted-average cost of capital) is used in DCF (discounted cash flow) models to evaluate average-risk investment projects

scenario analysis

simultaneous effect on a decision variable of interest of changing the values of a set of input factors; a special form of sensitivity analysis that is appropriate when the variables in a decision model are interrelated

net present value (NPV)

the difference between the present value of future cash inflows and the present value of future cash outflows of an investment project

modified internal rate of return (MIRR)

the internal rate of return (IRR) of a capital investment adjusted to account for an assumed rate of return associated with interim project cash inflows

payback period

the length of time (in years, months, etc.) required for the cumulative after-tax cash inflows from an investment to recover the initial investment outlay

present value (or discounted) payback period

the length of time required for the cumulative present value of after-tax cash inflows to recover the initial investment outlay

capital structure

the means by which a company is financed; the mix between debt and equity capital

hurdle rate

the minimum acceptable rate of return on an investment for capital budgeting purposes, also referred to as the required rate of return' for average-risk projects, the hurdle rate is defined as the weighted-average cost of capital (WACC)

breakeven after-tax cash flow

the minimum annual after-tax cash inflows needed for an investment project to be acceptable (in a present value sense)

sensitivity analysis

the name for a variety of methods that examine how an amount changes if factors involved in predicting that amount change

strategic control system

the processes an organization uses to monitor its progress in terms of accomplishing its strategic goals

market risk premium

the spread between the expected rate of return on a market portfolio of securities and the risk-free rate of return; represented as (Rm -Rf), where Rm = return on a market portfolio of securities and Rf = risk-free rate of return

dependent projects

those projects whose cash flows are affected by the cash flows associated with other projects

independent projects

those projects whose cash flows are not affected by the cash flows of other projects

in the determination of the weighted-average NPV of the project...

we include only those individual scenarios that have a positive NPV