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17 terms

payback period

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

net present value (NPV)

A sophisticated capital budgeting technique; found by subtracting a project's initial investment from the present value of its cash inflows discounted at a rate equal to the firm's cost of capital.

internal rate of return (IRR)

A sophisticated capital budgeting technique; the discount rate that equates eh NPV of an investment opportunity with $0 (because the present value of cash inflows equals the initial investment); it is the compound annual rate of return that the firm will earn if it invests in the project and receives the given cah inflows.

net present value profile

Graph that depicts a project's NPVs for various discount rates.

conflicting rankings

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

intermediate cash inflows

Cash inflows received prior to the termination of a project.

multiple IRRs

More than one IRR resulting from a capital budgeting project with a nonconventional cash flow pattern; the maximum number of IRRs for a project is equal to the number of sign changes in its cash flows.

real options

Opportunities that are embedded in capital projects that enable managers to alter their cash flows and risk in a way that affects project acceptability (NPV). Also called strategic options.

internal rate of return approach

An approach to capital rationing that involves graphing project IRRs in descending order against the total dollar investment to determine the group of acceptable projects.

investment opportunities schedule (IOS)

The graph that plots project IRRs in descending order against the total dollar investment.

net present value approach

An approach to capital rationing that is based on the use of present values to determine the group of projects that will maximized owners' wealth.

risk (in capital budgeting)

The chance that a project will prove unacceptable or, more formally, the degree of variability of cash flows.

decision trees

A behavioral approach that uses diagrams to map the various investment decision alternative and payoffs, along with their probabilities of occurrence.

simulation

A statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.

exchange rate risk

The danger that an unexpected change in the exchange rate between the dollar and the currency in which a project's cash flows are denominated will reduce the market value of that project's cash flow.

transfer prices

Prices that subsidiaries charge each other for the goods and services traded between them.

risk-adjusted discount rate (RADR)

The rate of return that must be earned on a given project to compensate the firm's owners adequately -- that is, to maintain or improve the firm's share price.