IFMP Capital Budgeting – Corporate Finance Certification (CBCFC), Pakistan flashcards

32 cards. Read the term and the definition here. The deck at the top of this page is optional.

Net present value

The sum of a project's future cash flows discounted at the cost of capital, minus the initial outlay. A positive NPV adds shareholder value and signals acceptance of the project.

Internal rate of return

The discount rate that makes a project's NPV equal to zero. Accept a conventional project when its IRR exceeds the required rate of return; beware multiple IRRs with unconventional cash flows.

Profitability index

Present value of future cash inflows divided by the initial outlay. A PI above 1 means positive NPV, and ranking by PI is the standard method under capital rationing.

Payback period

The time required for cumulative cash inflows to equal the initial investment. It measures liquidity and risk exposure but ignores cash flows after the cutoff and the time value of money.

Discounted payback period

The time until cumulative discounted cash inflows recover the initial outlay. It corrects payback's failure to discount but still ignores all cash flows arising after the cutoff date.

Accounting rate of return

Average annual accounting profit divided by average investment, usually (initial cost plus salvage) divided by two. It uses profit rather than cash flow and ignores the time value of money.

Incremental cash flow

The change in a firm's total cash flow caused by accepting a project. It includes opportunity costs and lost sales but excludes sunk costs and financing costs already reflected in the discount rate.

Sunk cost

A cost already incurred and unaffected by the accept-or-reject decision, such as past research spending. It must be excluded from project appraisal because it does not change with the decision.

Opportunity cost

The cash flow forgone by using an asset or resource in a project, such as rental income lost on a building used for the project. It is a relevant cash outflow in appraisal.

Depreciation tax shield

The tax saved because depreciation is a deductible expense, equal to depreciation multiplied by the tax rate. It is treated as a cash inflow occurring in the year the allowance arises.

After-tax salvage value

Sale proceeds minus tax on the gain, where gain equals proceeds minus tax written-down value. A loss on disposal produces a tax credit and therefore increases the after-tax proceeds.

Working capital recovery

The release of net working capital tied up in a project, occurring at the end of the project's life. The initial investment in working capital is an outflow at the start.

Equivalent annual annuity

A project's NPV converted into a level annual amount over its life using the annuity factor. Used to compare mutually exclusive projects with unequal lives; choose the highest EAA.

Capital rationing

A situation where the capital budget is insufficient to fund all positive-NPV projects. Divisible projects are ranked by profitability index; indivisible projects require combination or linear programming analysis.

Sensitivity margin

The percentage change in one input that reduces a project's NPV to zero, calculated as NPV divided by the present value of that input's cash flow effect. A small margin signals high risk.

Scenario analysis

Recalculating NPV under a small number of consistent alternative states, such as worst, base, and best cases, with several inputs changed together. It shows the range of possible outcomes.

Monte Carlo simulation

A technique that assigns probability distributions to uncertain project inputs and repeatedly samples them to generate a distribution of NPVs, giving expected value and standard deviation of NPV.

Real option to abandon

The right to sell or stop a project before the end of its planned life. This flexibility adds value beyond static NPV when salvage proceeds are significant relative to continuing losses.

Weighted average cost of capital

The after-tax average cost of a firm's debt and equity, weighted by market values: (E/V)Ke plus (D/V)Kd(1 minus tax rate). It is the standard discount rate for average-risk projects.

Cost of equity by CAPM

Risk-free rate plus beta multiplied by the market risk premium. It prices only systematic risk, so the beta used should reflect the business risk of the project being appraised.

Dividend growth model

Cost of equity equals next year's dividend divided by current share price, plus the expected growth rate. It requires a constant growth rate lower than the cost of equity.

Unlevering beta

Removing the effect of financial gearing from an observed equity beta: beta-unlevered equals beta-levered divided by [1 plus (1 minus tax rate) times debt-to-equity]. Used to find comparable business risk.

Relevering beta

Applying the target capital structure to an unlevered beta: beta-levered equals beta-unlevered multiplied by [1 plus (1 minus tax rate) times debt-to-equity]. Gives the project-specific equity beta.

Nominal and real rates

The Fisher relationship links them: real rate approximately equals nominal rate minus inflation, or exactly (1 plus nominal) divided by (1 plus inflation) minus one. Match nominal cash flows to nominal rates.

Mid-year discounting convention

An assumption that cash flows arise evenly through the year rather than at year-end. Each flow is discounted by an extra half-year, multiplying the NPV by the square root of (1 plus r).

Replacement decision analysis

Appraisal comparing the incremental cash flows of buying a new asset against keeping the old one, including after-tax proceeds from selling the old asset now and lost future salvage value.

Tax written-down value

The remaining tax basis of an asset after cumulative tax depreciation. It determines the taxable gain or loss, and hence the tax, when the asset is eventually sold.

Hard versus soft rationing

Hard rationing arises from external constraints on raising finance; soft rationing is a self-imposed internal limit. Both require ranking projects rather than accepting every positive-NPV project.

Foreign project appraisal

Appraising overseas projects either by discounting foreign-currency cash flows at the foreign cost of capital and translating NPV at spot, or by translating flows at forward rates and discounting at home cost of capital.

Post-completion audit

A review comparing actual project results with the original appraisal. It improves future forecasting and can reveal systematic optimism, but cannot reverse a decision already taken.

Capital budgeting process

The sequence of identifying investment opportunities, screening and appraising them, approving, implementing, and monitoring. Appraisal uses discounted cash flow methods; monitoring uses post-completion audits.

Mutually exclusive projects

Projects where accepting one prevents accepting another. Ranking by NPV is correct for value maximisation; IRR ranking can mislead when project scale or timing of cash flows differs.