capital budgeting -The process of evaluating and
selecting long-term investments that are consistent
with the firm’s goal of maximizing owners’ wealth.
capital expenditure - An outlay of funds by the firm
that is expected to produce benefits over a period of
time greater than 1 year.
operating expenditure - An outlay of funds by the
firm resulting in benefits received within 1 year.
capital budgeting process - Five distinct but
interrelated steps: proposal generation, review and
analysis, decision making, implementation, and
follow-up. (PRDIF)
independent projects - Projects whose cash flows are
unrelated to (or independent of) one another; the
acceptance of one does not eliminate the others
from further consideration.
mutually exclusive projects - Projects that compete
with one another, so that the acceptance of one
eliminates from further consideration all other
projects that serve a similar function.
unlimited funds - The financial situation in which a
firm is able to accept all independent projects that
provide an acceptable return.
capital rationing - The financial situation in which a
firm has only a fixed number of dollars available for
capital expenditures, and numerous projects
compete for these dollars.
accept–reject approach - The evaluation of capital
expenditure proposals to determine whether they
meet the firm’s minimum acceptance criterion.
ranking approach - The ranking of capital
expenditure projects on the basis of some
predetermined measure, such as the rate of return.
payback period - The amount of time required for a
firm to recover its initial investment in a project, as
calculated from cash inflows.
• If the payback period is less than the maximum
acceptable payback period, accept the project.
• If the payback period is greater than the maximum
acceptable payback period, reject the project.
net present value (NPV) - A sophisticated capital
budgeting technique; found by subtracting a
project’s initial investment from the present value of
its cash inflows discounted at a rate equal to the
firm’s cost of capital.
• If the NPV is greater than $0, accept the project.
• If the NPV is less than $0, reject the project.
A variation of the NPV rule is called the profitability
index (PI).
profitability index (PI) is simply equal to the present
value of cash inflows divided by the initial cash
outflow
pure economic profit A profit above and beyond the
normal competitive rate of return in a line of
business.
internal rate of return (IRR) The discount rate that
equates the NPV of an investment opportunity with
$0 (because the present value of cash inflows equals
the initial investment); it is the rate of return that the
firm will earn if it invests in the project and receives
the given cash inflows.
• If the IRR is greater than the cost of capital, accept
the project.
• If the IRR is less than the cost of capital, reject the
project.
net present value profile Graph that depicts a
project’s NPVs for various discount rates.
conflicting rankings Conflicts in the ranking given a
project by NPV and IRR, resulting from differences in
the magnitude and timing of cash flows.
intermediate cash inflows Cash inflows received
prior to the termination of a project.
relevant cash flows The incremental cash outflow
(investment) and resulting subsequent inflows
associated with a proposed capital expenditure.
incremental cash flows The additional cash flows—
outflows or inflows—expected to result from a
proposed capital expenditure.
initial investment The relevant cash outflow for a
proposed project at time zero.
operating cash inflows The incremental after-tax
cash inflows resulting from implementation of a
project during its life.
terminal cash flow The after-tax nonoperating cash
flow occurring in the final year of a project. It is
usually attributable to liquidation of the project.
sunk costs Cash outlays that have already been made
(past outlays) and therefore have no effect on the
cash flows relevant to a current decision.
opportunity costs Cash flows that could be realized
from the best alternative use of an owned asset.
foreign direct investment The transfer of capital,
managerial, and technical assets to a foreign
country.
cost of new asset The net outflow necessary to
acquire a new asset.
installation costs Any added costs that are necessary
to place an asset into operation.
installed cost of new asset The cost of new asset plus
its installation costs; equals the asset’s depreciable
value.
after-tax proceeds from sale of old asset The
difference between the old asset’s sale proceeds and
any applicable taxes or tax refunds related to its sale.
proceeds from sale of old asset The cash inflows, net
of any removal or cleanup costs, resulting from the
sale of an existing asset.
tax on sale of old asset Tax that depends on the
relationship between the old asset’s sale price and
book value and on existing government tax rules.
book value The strict accounting value of an asset,
calculated by subtracting its accumulated
depreciation from its installed cost.
recaptured depreciation The portion of an asset’s
sale price that is above its book value and below its
initial purchase price.
net working capital The difference between the
firm’s current assets and its current liabilities.
change in net working capital The difference
between a change in current assets and a change in
current liabilities.
risk (in capital budgeting) The uncertainty
surrounding the cash flows that a project will
generate or, more formally, the degree of variability
of cash flows.
breakeven cash inflow The minimum level of cash
inflow necessary for a project to be acceptable, that
is, NPV $0.
Scenario analysis is a behavioral approach that uses
several possible alternative outcomes (scenarios), to
obtain a sense of the variability of returns, measured
here by NPV. This technique is often useful in getting
a feel for the variability of return in response to
changes in a key outcome.
simulation A statistics-based behavioral approach
that applies predetermined probability distributions
and random numbers to estimate risky outcomes.
range can be determined by subtracting the
pessimistic-outcome NPV from the optimistic-
outcome NPV.
exchange rate risk The danger that an unexpected
change in the exchange rate between the dollar and
the currency in which a project’s cash flows are
denominated will reduce the market value of that
project’s cash flow.
transfer prices Prices that subsidiaries charge each
other for the goods and services traded between
them.
risk-adjusted discount rate (RADR) The rate of return
that must be earned on a given project to
compensate the firm’s owners adequately—that is,
to maintain or improve the firm’s share price.
capital asset pricing model (CAPM) to link the
relevant risk and return for all assets traded in
efficient markets. In the development of the CAPM,
the total risk of an asset was defined as
total risk = nondiversifiable risk + diversifiable risk
diversifiable risk results from uncontrollable or
random events
nondiversifiable risk— or relevant risk, the risk for
which owners of these assets are rewarded.
Nondiversifiable risk for securities is commonly
measured by using beta, which is an index of the
degree of movement of an asset’s return in response
to a change in the market return.
annualized net present value (ANPV) approach An
approach to evaluating unequal-lived projects that
converts the net present value of unequal-lived,
mutually exclusive projects into an equivalent annual
amount (in NPV terms).
real options Opportunities that are embedded in
capital projects that enable managers to alter their
cash flows and risk in a way that affects project
acceptability (NPV). Also called strategic options.
Abandonment option The option to abandon or
terminate a project prior to the end of its planned
life. This option allows management to avoid or
minimize losses on projects that turn bad. Explicitly
recognizing the abandonment option when
evaluating a project often increases its NPV.
Flexibility option The option to incorporate flexibility
into the firm’s operations, particularly production. It
generally includes the opportunity to design the
production process to accept multiple inputs, use
flexible production technology to create a variety of
outputs by reconfiguring the same plant and
equipment, and to purchase and retain excess
capacity in capital-intensive industries subject to
wide swings in output demand and long lead time in
building new capacity from scratch. Recognition of
this option embedded in a capital expenditure
should increase the NPV of the project.
Growth option The option to develop follow-on
projects, expand markets, expand or retool plants,
and so on, that would not be possible without
implementation of the project that is being
evaluated. If a project being considered has the
measurable potential to open new doors if
successful, then recognition of the cash flows from
such opportunities should be included in the initial
decision process. Growth opportunities embedded
in a project often increase the NPV of the project in
which they are embedded.
Timing option The option to determine when various
actions with respect to a given project are taken. This
option recognizes the firm’s opportunity to delay
acceptance of a project for one or more periods, to
accelerate or slow the process of implementing a
project in response to new information, or to shut
down a project temporarily in response to changing
product market conditions or competition. As in the
case of the other types of options, the explicit
recognition of timing opportunities can improve the
NPV of a project that fails to recognize this option in
an investment decision.
internal rate of return approach An approach to
capital rationing that involves graphing project IRRs
in descending order against the total dollar
investment to determine the group of acceptable
projects. investment
opportunities schedule (IOS) The graph that plots
project IRRs in descending order against the total
dollar investment.
net present value approach An approach to capital
rationing that is based on the use of present values
to determine the group of projects that will
maximize owners’ wealth.
leverage Refers to the effects that fixed costs have pecking order A hierarchy of financing that begins
on the returns that shareholders earn; higher with retained earnings, which is followed by debt
leverage generally results in higher but more volatile financing and finally external equity financing.
returns.
signal A financing action by management that is
capital structure The mix of long-term debt and believed to reflect its view of the firm’s stock value;
equity maintained by the firm. generally, debt financing is viewed as a positive
signal that management believes the stock is
breakeven analysis Used to indicate the level of
“undervalued,” and a stock issue is viewed as a
operations necessary to cover all costs and to
negative signal that management believes the stock
evaluate the profitability associated with various
is “overvalued.”
levels of sales; also called cost-volume-profit
analysis . optimal capital structure The capital structure at
which the weighted average cost of capital is
operating breakeven point The level of sales
minimized, thereby maximizing the firm’s value.
necessary to cover all operating costs; the point at
which EBIT $0. EBIT–EPS approach An approach for selecting the
capital structure that maximizes earnings per share
total operating cost—the sum of its fixed and
(EPS) over the expected range of earnings before
variable operating costs
interest and taxes (EBIT).
operating leverage The use of fixed operating costs
financial breakeven point The level of EBIT necessary
to magnify the effects of changes in sales on the
to just cover all fixed financial costs; the level of EBIT
firm’s earnings before interest and taxes.
for which EPS $0.
degree of operating leverage (DOL) The numerical
measure of the firm’s operating leverage.

financial leverage The use of fixed financial costs to

magnify the effects of changes in earnings before
interest and taxes on the firm’s earnings per share

degree of financial leverage (DFL) The numerical

measure of the firm’s financial leverage.

total leverage The use of fixed costs, both operating

and financial, to magnify the effects of changes in
sales on the firm’s earnings per share.

degree of total leverage (DTL) The numerical

measure of the firm’s total leverage.

Capital structure is one of the most complex areas of

financial decision making because of its
interrelationship with other financial decision
variables.

asymmetric information The situation in which

managers of a firm have more information about
operations and future prospects than do investors.