Finance Ch. 11

Capital Rationing

a situation in which a firm's access to capital is limited such that it is unable to undertake all projects that have positive NPVs

Equivalent Annual Cost (EAC)

The annuity cash flow amount that is equivalent to the present value of the project's cost

Independent Investment Project

An investment project whose acceptance will not affect the acceptance or rejection of any other project

Mutually exclusive projects

related or dependent investment proposals where the acceptance of one proposal means the rejection of the other

Net Present Value (NPV)

the difference in the present value of an investment proposal's future cash flows and the initial cash outlay. This difference is the expected increase in value of the firm due to the acceptance of the project

Discounted payback period

the number of years required for a project's discounted cash flows to recover the initial cash outlay for an investment

Internal rate of return (IRR)

the compound annual rate of return earned by an investment

Modified Internal Rate of Return

the compound annual rate of return earned by an investment whose cash flows have been moved through time so as to eliminate the problem of multiple IRRs. For example, all negative cash flows after Year 0 are discounted back to Year 0 using the firm's required rate of return and then the IRR is determined for this modified cash flow stream

NPV profile

a plot of multiple NPV estimates calculated using a succession of different discount rates. This profile illustrates when there are multiple IRRs, that is, where NPV is equal to zero for more than one discount rate

Payback period

the number of future cash flows needed to recover the initial investment in a proposed project

Profitability Index

the ratio of the present value of the expected future cash flows for an investment proposal (discounted using the required rate of return for the project) divided by the initial investment in the project