Principles of Finance: Chapters 4, 5, and 6 Study Guide

Vocabulary terms and definitions covering valuation, capital budgeting rules, and incremental cash flow concepts from Chapters 4, 5, and 6.

Net Present Value (NPV)

The present value of future cash flows minus initial cost (accept if $NPV > 0$).

CALC PV

Perpetuity

A constant cash flow stream that lasts forever.

Annuity

A constant cash flow stream with a fixed number of periods.

Ordinary Annuity

Payment happens at the end of each period.

Annuity Due

Payment happens at the beginning of each period.

Capital Budgeting

The process of choosing projects that create value for the company.

Payback Period

Tells the number of years required to recoup an investment; compared to useful life.

INITIAL COST / ANNUAL CASH FLOWS

Discounted Payback Period

A payback period variation that takes the time value of money into consideration.

Internal Rate of Return (IRR)

The percentage rate where $NPV = 0$; used to decide whether to invest.

CALC FOR 1/Y

Profitability Index (PI)

A measure that takes subsequent cash flows into consideration (accept if $PI > 1$).

Incremental Cash Flows

The change in cash flows resulting directly from accepting a project.

Sunk Costs

Historical costs that are irrelevant in the decision-making process.

Opportunity Costs

Cash flows lost or forgone by taking one course of action over another; used in decision-making processes.