Long Term Investment Decision (Topic 6) Vocabulary

A comprehensive set of vocabulary flashcards covering the key concepts, process steps, and financial techniques involved in long-term investment decisions and capital budgeting.

Capital budgeting

The process of evaluating and selecting long-term investments that are consistent with the firm's goal of maximizing owner 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.

Proposal generation

The first step in the capital budgeting process where proposals for new investment projects are made at all levels within a business organization.

Review and analysis

The second step in the capital budgeting process where financial managers perform formal review and analysis to assess the merits of investment proposals.

Implementation

The fourth step in the capital budgeting process where expenditures are made and projects are put into action following approval.

Follow-up

The final step in the capital budgeting process where results are monitored and actual costs and benefits are compared with expectations.

Independent projects

Projects whose cash flows are unrelated to 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

A financial situation in which a firm is able to accept all independent projects that provide an acceptable return.

Capital rationing

A 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 method

The amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows.

Average Accounting Return (AAR)

A capital budgeting technique that evaluates an investment project by focusing on its impact on financial statements, specifically calculating profit relative to the book value of assets.

Average Accounting Return formula

$$AAR = \frac{\text{Average Net Income}}{\text{Average Book Value}}$$

Net Present Value (NPV)

A sophisticated capital budgeting technique that calculates the difference between the present value of cash inflows and outflows over time: $NPV = \text{Present value of cash inflows} - \text{Initial investment}$

Profitability Index (PI)

A measure used to evaluate investment opportunities, calculated as: $PI = \frac{\text{PV of cash inflows}}{\text{Initial cash outflow}}$

Internal Rate of Return (IRR)

The discount rate that makes the $NPV$ of an investment equal to $0$; it represents the rate of return the firm will earn if it invests in the project.

Conflicting rankings

Conflicts in the ranking given to a project by $NPV$ and $IRR$, resulting from differences in the magnitude and timing of cash flows.

NPV reinvestment assumption

The implicit assumption that intermediate cash flows are reinvested at the cost of capital.

IRR reinvestment assumption

The implicit assumption that intermediate cash flows are reinvested at the internal rate of return ($IRR$).

Non-conventional cash flow

A cash flow pattern where the sign changes more than once, such as an initial cost followed by positive cash flows and then a negative cash flow to close the project.