Capital Budgeting - Final Exam

corporate finance

A set of principles for how we run businesses with the objective to maximize the value of the business

investing decision (in corporate finance)

how a company decides which projects to undertake

financing decision (in corporate finance)

how a company decides on the amount of debt and equity to use for each project

distribution decision (in corporate finance)

how a company decides how much profit to reinvest back into the business to grow and how much profit to return to the owners of the company

liquidity decision (in corporate finance)

how a company decides the amount of short-term assets and liabilities to ensure they have enough cash to operate and meet obligations

capital budgeting

the process of determining which projects the company should undertake to maximize the value of the business (which is to maximize the distributable cash profit to its owners)

capital

cash used to purchase assets which will generate future cash profit for the business

project

investment opportunities (long-term assets) that involve spending cash today (capital expenditure) with the aim at generating more cash in the future (operating cash flow)

cash inflow

money received by a company from its various activities

cash outflow

money spent by a company from its various activities

capital expenditure (capex)

money spent by a business to acquire assets

investment (as a capex)

using cash from investors (bondholders or stockholders) to purchase assets to generate profit in the future

re-investment (as a capex)

using profits generated from existing assets to purchase more assets to generate more profit in the future

operating cash flow

money generated by the assets of the business

accrual profit

the profit of the business as listed on the income statement, emphasizing the timing of transactions (net income)

cash profit

the profit of the business as listed on the cash flow statement, emphasizing the timing of cash (cash flow from operations)

maintenance project

projects aimed at continuing current operations by replacing damaged equipment, obsolete equipment, or required equipment by law.

expansion project

projects aimed at growing the business by increasing the amount of profit generating assets

net present value (NPV)

the difference between the present value of cash inflows (positive, profit, operating cash flow) and the present value of cash outflows (negative, expense, capex); represents how much the intrinsic value of the business will increase by undertaking the project

internal rate of return (IRR)

the rate of return the project needs to contribute no additional value to the business; the breakeven point of the project; the minimum rate of return the project needs to achieve to cover its costs

modified internal rate of return (MIRR)

the rate of return the project is expected to earn if the cash inflows are reinvested at the MIRR while the cash outflows are financed at the cost of capital

payback period

the amount of time required for a project to produce cash flows equal to its initial cost

discounted payback

the amount of time required for a project to produce discounted cash flows equal to its initial cost

profitability index (PI)

the value created by the project for the business per dollar invested in the project

equivalent annual annuity (EAA)

the constant annual cash flow generated by a project over its life; how much value is being added to the business each year "on average"

optimal capital budget

the investment in long-term assets or projects which maximize the company's intrinsic value; consists of all independent projects with positive NPVs plus mutually exclusive projects with the highest positive NPVs which the company can afford to invest in

capital budget

a list of projects that a company intends to undertake with its limited capital