Advanced Topics in Capital Budgeting
Expert-defined terms from the Advanced Certificate in Budgeting For Capital Expenditures course at London School of Planning and Management. Free to read, free to share, paired with a professional course.
Abandonment Value refers to the value of a project or asset when it is ab… #
Related terms include salvage value, residual value, and termination value. Abandonment value is the estimated value of a project or asset at the end of its useful life, and it can be a significant factor in determining the overall profitability of a project. For example, a company may abandon a project if the expected abandonment value is higher than the expected costs of continuing the project.
Absolute Advantage is a concept in international trade that refers to a c… #
Related terms include comparative advantage, gains from trade, and trade surplus. Absolute advantage is an important consideration in capital budgeting decisions, as companies may choose to invest in countries with an absolute advantage in producing certain goods or services. For instance, a company may choose to invest in a country with an absolute advantage in producing textiles, as it can produce textiles at a lower cost than other countries.
Accounting Rate of Return (ARR) is a metric used to evaluate the profitab… #
Related terms include return on investment (ROI), internal rate of return (IRR), and payback period. ARR is an important consideration in capital budgeting decisions, as it provides a simple and straightforward measure of a project's profitability. For example, a company may use ARR to evaluate the profitability of a new project, and choose to invest in it if the ARR is higher than the company's cost of capital.
Adjusted Present Value (APV) is a method used to evaluate the value of a… #
Related terms include weighted average cost of capital (WACC), cost of equity, and cost of debt. APV is an important consideration in capital budgeting decisions, as it provides a more accurate measure of a project's value than other methods. For instance, a company may use APV to evaluate the value of a new project, and choose to invest in it if the APV is higher than the company's cost of capital.
Agency Cost refers to the costs associated with the agency problem … #
Related terms include agency theory, principal-agent problem, and corporate governance. Agency cost is an important consideration in capital budgeting decisions, as it can affect the profitability of a project or investment. For example, a company may incur agency costs if the management team is not acting in the best interests of the shareholders.
Amortization is the process of gradually writing off the cost of an intan… #
Related terms include depreciation, amortization schedule, and intangible assets. Amortization is used to allocate the cost of an intangible asset, such as a patent or copyright, over its useful life. For instance, a company may amortize the cost of a patent over its useful life of 10 years, and recognize the amortization expense in its income statement.
Annual Percentage Rate (APR) is a metric used to evaluate the cost of bor… #
Related terms include nominal interest rate, effective interest rate, and compounding frequency. APR is an important consideration in capital budgeting decisions, as it provides a measure of the cost of borrowing. For example, a company may use APR to evaluate the cost of borrowing from different lenders, and choose the lender with the lowest APR.
Annuity is a series of equal cash flows that occur at equal intervals ove… #
Related terms include annuity due, perpetuity, and present value. Annuity is used to evaluate the present value of a series of cash flows, such as a stream of rental income or a series of interest payments. For instance, a company may use annuity to evaluate the present value of a stream of rental income from a property, and choose to invest in the property if the present value is higher than the cost of investment.
Arbitrage is the process of taking advantage of a price difference betwee… #
Related terms include arbitrage opportunity, risk-free profit, and market efficiency. Arbitrage is used to earn a risk-free profit by buying an asset at a low price in one market and selling it at a high price in another market. For example, a company may engage in arbitrage by buying a security at a low price in one market and selling it at a high price in another market, and earning a risk-free profit.
Asset Beta is a metric used to evaluate the systematic risk of an asset,… #
Related terms include beta, systematic risk, and unsystematic risk. Asset beta is an important consideration in capital budgeting decisions, as it provides a measure of the asset's systematic risk. For instance, a company may use asset beta to evaluate the systematic risk of a new project, and choose to invest in it if the asset beta is lower than the company's target beta.
Asymmetric Information refers to a situation where one party has more or better… #
Related terms include information asymmetry, moral hazard, and adverse selection. Asymmetric information can affect the profitability of a project or investment, as it can lead to agency problems and information problems. For example, a company may incur costs due to asymmetric information if the management team has more information than the shareholders.
Autocorrelation refers to the correlation between a variable's current va… #
Related terms include autocorrelation coefficient, serial correlation, and random walk. Autocorrelation is used to evaluate the predictability of a variable, such as a stock price or a commodity price. For instance, a company may use autocorrelation to evaluate the predictability of a stock price, and choose to invest in the stock if the autocorrelation is high.
Average Collection Period is a metric used to evaluate the time it takes… #
Related terms include accounts receivable, average daily sales, and collection period. Average collection period is an important consideration in capital budgeting decisions, as it can affect the company's cash flow. For example, a company may choose to invest in a project that has a shorter average collection period, as it can improve the company's cash flow.
Average Cost of Capital is a metric used to evaluate the cost of capital… #
Average cost of capital is an important consideration in capital budgeting decisions, as it provides a measure of the company's cost of capital. For instance, a company may use average cost of capital to evaluate the profitability of a new project, and choose to invest in it if the project's return is higher than the company's average cost of capital.
Average Revenue Per User (ARPU) is a metric used to evaluate the revenue… #
Related terms include average revenue, user base, and revenue growth. ARPU is an important consideration in capital budgeting decisions, as it can affect the company's revenue and profitability. For example, a company may choose to invest in a project that has a high ARPU, as it can improve the company's revenue and profitability.
Beta is a metric used to evaluate the systematic risk of an asset, and it… #
Related terms include asset beta, systematic risk, and unsystematic risk. Beta is an important consideration in capital budgeting decisions, as it provides a measure of the asset's systematic risk. For instance, a company may use beta to evaluate the systematic risk of a new project, and choose to invest in it if the beta is lower than the company's target beta.
Binomial Distribution is a probability distribution that is used to model… #
Related terms include binomial probability, probability distribution, and risk analysis. Binomial distribution is used to evaluate the probability of success or failure in a binary outcome, such as a coin toss or a stock price movement. For example, a company may use binomial distribution to evaluate the probability of success of a new project, and choose to invest in it if the probability of success is high.
Black #
Scholes Model is a model used to evaluate the value of a call option or a put option, and it is an important consideration in capital budgeting decisions. Related terms include option pricing, volatility, and risk-free rate. Black-Scholes model is used to evaluate the value of a call option or a put option, and it takes into account the time to expiration, the strike price, the underlying asset price, the risk-free rate, and the volatility of the underlying asset. For instance, a company may use Black-Scholes model to evaluate the value of a call option on a stock, and choose to invest in the stock if the option value is high.
Break #
Even Analysis is a method used to evaluate the point at which a project or investment becomes profitable, and it is an important consideration in capital budgeting decisions. Related terms include break-even point, contribution margin, and fixed costs. Break-even analysis is used to evaluate the point at which a project or investment becomes profitable, and it takes into account the fixed costs, variable costs, and revenue. For example, a company may use break-even analysis to evaluate the profitability of a new project, and choose to invest in it if the break-even point is lower than the expected sales.
Capital Asset Pricing Model (CAPM) is a model used to evaluate the expect… #
Related terms include expected return, beta, and risk-free rate. CAPM is used to evaluate the expected return of an asset, and it takes into account the risk-free rate, the market return, and the beta of the asset. For instance, a company may use CAPM to evaluate the expected return of a new project, and choose to invest in it if the expected return is higher than the company's cost of capital.
Capital Budgeting is the process of evaluating and selecting investment p… #
Related terms include capital expenditure, investment project, and project evaluation. Capital budgeting is used to evaluate and select investment projects, and it takes into account the expected return, risk, and cost of capital. For example, a company may use capital budgeting to evaluate the profitability of a new project, and choose to invest in it if the expected return is higher than the company's cost of capital.
Capital Expenditure is a type of expenditure that is used to acquire or i… #
Related terms include capital budgeting, investment project, and asset acquisition. Capital expenditure is used to acquire or improve a long-term asset, such as a building or a machine, and it is expected to generate benefits over a long period of time. For instance, a company may use capital expenditure to acquire a new machine, and choose to invest in it if the expected benefits are higher than the cost of the machine.
Capital Rationing is the process of allocating a limited amount of capita… #
Related terms include capital budgeting, investment project, and project evaluation. Capital rationing is used to allocate a limited amount of capital to different investment projects, and it takes into account the expected return, risk, and cost of capital. For example, a company may use capital rationing to evaluate the profitability of different projects, and choose to invest in the projects with the highest expected return.
Capital Structure is the mix of debt and equity that a company uses to fi… #
Related terms include debt financing, equity financing, and cost of capital. Capital structure is used to evaluate the mix of debt and equity that a company uses to finance its operations, and it takes into account the cost of debt, the cost of equity, and the risk of default. For instance, a company may use capital structure to evaluate the optimal mix of debt and equity, and choose to invest in projects that have a lower cost of capital.
Cash Flow is the movement of money into or out of a company, and it is an… #
Related terms include cash inflow, cash outflow, and net cash flow. Cash flow is used to evaluate the movement of money into or out of a company, and it takes into account the revenue, expenses, and investments. For example, a company may use cash flow to evaluate the profitability of a new project, and choose to invest in it if the expected cash flow is positive.
Certainty Equivalent is a method used to evaluate the value of a risky in… #
Related terms include risk-free rate, expected return, and risk premium. Certainty equivalent is used to evaluate the value of a risky investment, and it takes into account the risk-free rate, the expected return, and the risk premium. For instance, a company may use certainty equivalent to evaluate the value of a new project, and choose to invest in it if the certainty equivalent is higher than the cost of investment.
Compounding is the process of earning interest on both the principal amou… #
Related terms include compound interest, interest rate, and time value of money. Compounding is used to evaluate the future value of an investment, and it takes into account the interest rate, the principal amount, and the time period. For example, a company may use compounding to evaluate the future value of a savings account, and choose to invest in it if the expected return is higher than the company's cost of capital.
Cost of Capital is the cost of raising funds to finance a company's opera… #
Related terms include cost of debt, cost of equity, and weighted average cost of capital (WACC). Cost of capital is used to evaluate the cost of raising funds to finance a company's operations, and it takes into account the cost of debt, the cost of equity, and the risk of default. For instance, a company may use cost of capital to evaluate the profitability of a new project, and choose to invest in it if the expected return is higher than the company's cost of capital.
Cost #
Benefit Analysis is a method used to evaluate the costs and benefits of a project or investment, and it is an important consideration in capital budgeting decisions. Related terms include cost, benefit, and net present value (NPV). Cost-benefit analysis is used to evaluate the costs and benefits of a project or investment, and it takes into account the expected costs, expected benefits, and the time value of money. For example, a company may use cost-benefit analysis to evaluate the profitability of a new project, and choose to invest in it if the expected benefits are higher than the expected costs.
Credit Risk is the risk that a borrower will default on a loan, and it is… #
Related terms include default risk, creditworthiness, and loan default. Credit risk is used to evaluate the risk that a borrower will default on a loan, and it takes into account the borrower's creditworthiness, the loan terms, and the collateral. For instance, a company may use credit risk to evaluate the risk of lending to a customer, and choose to lend to the customer if the credit risk is low.
Debt Financing is the process of raising funds by borrowing from lenders,… #
Related terms include debt, loan, and interest rate. Debt financing is used to raise funds by borrowing from lenders, and it takes into account the interest rate, the loan terms, and the collateral. For example, a company may use debt financing to raise funds to finance a new project, and choose to borrow from a lender if the interest rate is low.
Depreciation is the process of gradually writing off the cost of a tangib… #
Related terms include depreciation schedule, amortization, and intangible assets. Depreciation is used to allocate the cost of a tangible asset, such as a building or a machine, over its useful life. For instance, a company may depreciate the cost of a machine over its useful life of 5 years, and recognize the depreciation expense in its income statement.
Discount Rate is the rate at which a company discounts its future cash fl… #
Related terms include present value, future value, and time value of money. Discount rate is used to evaluate the present value of a future cash flow, and it takes into account the time value of money, the risk of the investment, and the expected return. For example, a company may use discount rate to evaluate the present value of a future cash flow, and choose to invest in a project if the present value is higher than the cost of investment.
Diversification is the process of spreading investments across different… #
Related terms include portfolio diversification, risk reduction, and asset allocation. Diversification is used to reduce the risk of a portfolio by spreading investments across different asset classes, such as stocks, bonds, and real estate. For instance, a company may use diversification to reduce the risk of its investment portfolio, and choose to invest in a mix of assets that have a low correlation with each other.
Dividend Yield is the ratio of the annual dividend payment to the stock p… #
Related terms include dividend, stock price, and dividend payout ratio. Dividend yield is used to evaluate the return on investment of a stock, and it takes into account the annual dividend payment and the stock price. For example, a company may use dividend yield to evaluate the return on investment of a stock, and choose to invest in the stock if the dividend yield is high.
Efficient Market Hypothesis (EMH) is a theory that states that financial… #
Related terms include market efficiency, random walk, and stock price movement. EMH is used to evaluate the efficiency of financial markets, and it takes into account the availability of information, the speed of information, and the rationality of market participants. For example, a company may use EMH to evaluate the efficiency of the stock market, and choose to invest in stocks if the market is efficient.
Expected Return is the expected return on investment, and it is an import… #
Related terms include expected value, risk premium, and cost of capital. Expected return is used to evaluate the expected return on investment, and it takes into account the risk-free rate, the risk premium, and the expected cash flows. For instance, a company may use expected return to evaluate the expected return on investment of a new project, and choose to invest in it if the expected return is higher than the company's cost of capital.
Financial Lease is a type of lease that transfers the risks and rewards o… #
Related terms include lease, lessee, and lessor. Financial lease is used to transfer the risks and rewards of ownership to the lessee, and it takes into account the lease terms, the asset value, and the interest rate. For example, a company may use financial lease to acquire a new machine, and choose to lease the machine if the lease terms are favorable.
Financial Statement Analysis is the process of analyzing a company's fina… #
Related terms include financial statement, financial ratio, and financial performance. Financial statement analysis is used to evaluate a company's financial performance, and it takes into account the income statement, the balance sheet, and the cash flow statement. For instance, a company may use financial statement analysis to evaluate the financial performance of a new project, and choose to invest in it if the financial performance is strong.
Firm #
Specific Risk is the risk that is unique to a particular company, and it is an important consideration in capital budgeting decisions. Related terms include unsystematic risk, idiosyncratic risk, and company-specific risk. Firm-specific risk is used to evaluate the risk that is unique to a particular company, and it takes into account the company's operations, management, and industry. For example, a company may use firm-specific risk to evaluate the risk of a new project, and choose to invest in it if the firm-specific risk is low.
Free Cash Flow is the cash flow that is available to investors after a co… #
Related terms include cash flow, operating expenses, and capital expenditures. Free cash flow is used to evaluate the cash flow that is available to investors, and it takes into account the operating expenses, capital expenditures, and working capital changes. For instance, a company may use free cash flow to evaluate the cash flow that is available to investors, and choose to invest in a project if the free cash flow is positive.
Gross Margin is the difference between the revenue and the cost of goods… #
Related terms include revenue, cost of goods sold, and gross margin ratio. Gross margin is used to evaluate the profitability of a company, and it takes into account the revenue, cost of goods sold, and gross margin ratio. For example, a company may use gross margin to evaluate the profitability of a new project, and choose to invest in it if the gross margin is high.
Hedging is the process of reducing risk by taking a position in a securit… #
Related terms include risk reduction, hedge, and derivatives. Hedging is used to reduce the risk of a portfolio by taking a position in a security that offsets the risk of another security, and it takes into account the risk of the underlying asset, the hedge ratio, and the cost of hedging. For instance, a company may use hedging to reduce the risk of a portfolio, and choose to hedge a position if the risk reduction is significant.
Incremental Cost is the additional cost of producing one more unit of a g… #
Related terms include marginal cost, average cost, and cost function. Incremental cost is used to evaluate the additional cost of producing one more unit of a good or service, and it takes into account the cost function, the production level, and the input prices. For example, a company may use incremental cost to evaluate the additional cost of producing one more unit of a product, and choose to produce the product if the incremental cost is lower than the selling price.
Internal Rate of Return (IRR) is a metric used to evaluate the expected r… #
Related terms include NPV, discount rate, and expected return. IRR is an important consideration in capital budgeting decisions, as it provides a measure of the expected return of an investment. For instance, a company may use IRR to evaluate the expected return of a new project, and choose to invest in it if the IRR is higher than the company's cost of capital.
Investment Project is a project that is undertaken to generate a return o… #
Related terms include capital budgeting, project evaluation, and investment analysis. Investment project is used to evaluate the profitability of a project, and it takes into account the expected return, risk, and cost of capital. For example, a company may use investment project to evaluate the profitability of a new project, and choose to invest in it if the expected return is higher than the company's cost of capital.
Leverage is the use of debt to finance a company's operations, and it is… #
Related terms include debt financing, equity financing, and financial leverage. Leverage is used to evaluate the use of debt to finance a company's operations, and it takes into account the debt-to-equity ratio, the interest rate, and the risk of default. For instance, a company may use leverage to finance a new project, and choose to borrow if the interest rate is low.
Liquidity is the ability to convert an asset into cash quickly and at a l… #
Related terms include liquidity risk, liquidity ratio, and cash flow. Liquidity is used to evaluate the ability to convert an asset into cash quickly and at a low cost, and it takes into account the liquidity risk, the liquidity ratio, and the cash flow. For example, a company may use liquidity to evaluate the ability to convert an asset into cash, and choose to invest in a project if the liquidity is high.
Marginal Cost is the additional cost of producing one more unit of a good… #
Related terms include incremental cost, average cost, and cost function. Marginal cost is used to evaluate the additional cost of producing one more unit of a good or service, and it takes into account the cost function, the production level, and the input prices. For instance, a company may use marginal cost to evaluate the additional cost of producing one more unit of a product, and choose to produce the product if the marginal cost is lower than the selling price.
Market Risk is the risk that is associated with the overall market, and i… #
Related terms include systematic risk, beta, and market volatility. Market risk is used to evaluate the risk that is associated with the overall market, and it takes into account the beta, the market volatility, and the risk-free rate. For example, a company may use market risk to evaluate the risk of a new project, and choose to invest in it if the market risk is low.
Merger is the combination of two or more companies to form a new company,… #
Related terms include acquisition, consolidation, and merger analysis. Merger is used to evaluate the combination of two or more companies to form a new company, and it takes into account the synergies, the cost savings, and the revenue growth. For instance, a company may use merger to evaluate the combination of two companies, and choose to merge if the expected synergies are significant.
Net Present Value (NPV) is a metric used to evaluate the expected return… #
Related terms include present value, discount rate, and expected return. NPV is an important consideration in capital budgeting decisions, as it provides a measure of the expected return of an investment. For example, a company may use NPV to evaluate the expected return of a new project, and choose to invest in it if the NPV is positive.
Operating Cash Flow is the cash flow that is generated by a company's ope… #
Operating cash flow is used to evaluate the cash flow that is generated by a company's operations, and it takes into account the revenue, operating expenses, and working capital changes. For instance, a company may use operating cash flow to evaluate the cash flow that is generated by a new project, and choose to invest in it if the operating cash flow is positive.
Opportunity Cost is the cost of choosing one option over another, and it… #
Related terms include cost, benefit, and trade-off. Opportunity cost is used to evaluate the cost of choosing one option over another, and it takes into account the expected benefits, the expected costs, and the trade-off between different options. For example, a company may use opportunity cost to evaluate the cost of choosing one project over another, and choose to invest in the project with the highest expected return.
Option is a contract that gives the holder the right, but not the obligat… #
Related terms include call option, put option, and option pricing. Option is used to evaluate the value of a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price, and it takes into account the time to expiration, the strike price, the underlying asset price, the risk-free rate, and the volatility of the underlying asset. For instance, a company may use option to evaluate the value of a call option on a stock, and choose to invest in the stock if the option value is high.
Payback Period is the time it takes for an investment to generate cash fl… #
Related terms include payback period, return on investment (ROI), and internal rate of return (IRR). Payback period is used to evaluate the time it takes for an investment to generate cash flows that equal the initial investment, and it takes into account the expected cash flows, the initial investment, and the discount rate. For example, a company may use payback period to evaluate the time it takes for a new project to generate cash flows that equal the initial investment, and choose to invest in it if the payback period is lower than the expected life of the project.
Portfolio Diversification is the process of spreading investments across… #
Related terms include risk reduction, hedge, and asset allocation. Portfolio diversification is used to reduce the risk of a portfolio by spreading investments across different asset classes, such as stocks, bonds, and real estate. For instance, a company may use portfolio diversification to reduce the risk of its investment portfolio, and choose to invest in a mix of assets that have a low correlation with each other.
Present Value is the value of a future cash flow in today's dollars, and… #
Related terms include discount rate, time value of money, and expected return. Present value is used to evaluate the value of a future cash flow in today's dollars, and it takes into account the discount rate, the time value of money, and the expected return. For example, a company may use present value to evaluate the value of a future cash flow, and choose to invest in it if the present value is higher than the cost of investment.
Profitability Index is a metric used to evaluate the profitability of an… #
Related terms include return on investment (ROI), internal rate of return (IRR), and net present value (NPV). Profitability index is an important consideration in capital budgeting decisions, as it provides a measure of the profitability of an investment. For instance, a company may use profitability index to evaluate the profitability of a new project, and choose to invest in it if the profitability index is higher than 1.
Real Option is a method used to evaluate the value of a project or invest… #
Related terms include option pricing, flexibility, and real options. Real option is used to evaluate the value of a project or investment that has flexibility or real options, and it takes into account the time to expiration, the strike price, the underlying asset price, the risk-free rate, and the volatility of the underlying asset. For example, a company may use real option to evaluate the value of a new project that has flexibility or real options, and choose to invest in it if the real option value is high.
Return on Investment (ROI) is a metric used to evaluate the return on inv… #
Related terms include return on equity (ROE), return on assets (ROA), and internal rate of return (IRR). ROI is an important consideration in capital budgeting decisions, as it provides a measure of the return on investment. For instance, a company may use ROI to evaluate the return on investment of a new project, and choose to invest in it if the ROI is higher than the company's cost of capital.
Risk Analysis is the process of evaluating and managing risk, and it is a… #
Related terms include risk assessment, risk management, and risk reduction. Risk analysis is used to evaluate! And manage risk, and it takes into account the risk assessment, the risk management, and the risk reduction. For example, a company may use risk analysis to evaluate the risk of a new project, and choose to invest in it if the risk is manageable.
Risk #
Adjusted Return is a metric used to evaluate the return on investment adjusted for risk, and it is calculated by dividing the expected return by the risk measure. Related terms include risk premium, expected return, and risk measure. Risk-adjusted return is an important consideration in capital budgeting decisions, as it provides a measure of the return on investment adjusted for risk. For instance, a company may use risk-adjusted return to evaluate the return on investment of a new project, and choose to invest in it if the risk-adjusted return is higher than the company's cost of capital.
Sensitivity Analysis is the process of evaluating how changes in assumpti… #
Related terms include scenario analysis, what-if analysis, and break-even analysis. Sensitivity analysis is used to evaluate how changes in assumptions affect the outcome of a decision, and it takes into account the changes in assumptions, the outcome of the decision, and the risk of the decision.