Exam 3 Vocab Quiz

sensitivity analysis

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

net present value (NPV)

The difference between an ­investment’s market value and its cost.

pro forma financial statements

Financial statements projecting future years’ operations.

net present value profile

A graphical representation of the relationship between an investment’s net present value and various discount rates.

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.

opportunity cost

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

multiple rates of return

The possibility that more than one discount rate will make the net present value of an investment zero.

average accounting return (AAR)

An investment’s average net income divided by its average book value.

erosion

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

internal rate of return (IRR)

The discount rate that makes the net present value of an investment zero.

depreciation tax shield

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

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.

profitability index (PI)

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

stand-alone principle

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

forecasting risk

The possibility that errors in projected cash flows will lead to incorrect decisions. Also estimation risk.

payback period

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

sunk cost

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