9.8: Key Terms

This section provides concise definitions of key capital budgeting, project evaluation, and risk analysis terms introduced in Chapter 9. These definitions are presented in a static, printable format for reference and exam preparation. When viewed online, additional dynamic highlighting of terms may be available.

Term	Definition
Abandonment option	A real option that gives management the right (not the obligation) to discontinue a project and recover some value (such as salvage) if results are unfavorable.
Base case	The most likely set of assumptions in scenario analysis, used as the benchmark for comparing best- and worst-case outcomes.
Break-even analysis (NPV break-even)	An analysis that solves for the value of a key input (such as price or volume) that makes NPV = 0, showing how much “cushion” the project has before value turns negative.
Capital budgeting	The process of evaluating and selecting long-term investments by comparing today’s costs to the present value of expected future cash flows.
Capital rationing	A situation where a firm has limited funds for investment and must choose among projects, aiming to maximize total NPV within the budget constraint.
Crossover rate	The discount rate at which two mutually exclusive projects have the same NPV; found by computing the IRR of the difference in their cash flows (ΔCF).
Discount rate (required return)	The rate used to discount future cash flows to present value, reflecting the time value of money and the risk of the project.
Discounted payback period	The time required for the cumulative present value of cash inflows to recover the initial investment (incorporates the time value of money).
Divisible project	A project that can be scaled up or down (partially funded). Under capital rationing, ranking by PI is most relevant for divisible projects.
Equivalent annual annuity (EAA)	A method for comparing projects with unequal lives by converting each project’s NPV into an equivalent constant annual value: \(\text{EAA}=\text{NPV}\times\frac{r}{1-(1+r)^{-n}}\).
Hard rationing	Capital constraints imposed externally (for example, lenders or markets restrict financing), creating a binding spending limit even if attractive projects exist.
Incremental cash flows	The additional cash inflows and outflows that occur because the project is undertaken; the relevant cash flows for capital budgeting decisions.
Indivisible project	A project that must be accepted or rejected in full. Under capital rationing, managers compare feasible combinations to maximize total NPV.
Internal rate of return (IRR)	The discount rate that makes a project’s NPV equal to zero. Accept if IRR exceeds the required return, recognizing IRR can mis-rank mutually exclusive projects.
Mutually exclusive projects	Projects where accepting one means rejecting the other(s). The correct decision rule is to choose the project with the higher NPV at the required return.

Term	Definition
Net present value (NPV)	The present value of future cash inflows minus the initial investment. NPV measures total dollar value created; accept if NPV > 0.
NPV profile	A graph of NPV versus discount rate. Used to visualize ranking conflicts and identify crossover rates between projects.
Payback period	The time required for cumulative nominal cash inflows to recover the initial investment. It is a liquidity screen and ignores the time value of money.
Profitability index (PI)	A ratio measuring present value of inflows per dollar invested: \(\text{PI}=\frac{\text{PV(inflows)}}{|\text{CF}_0|}\). Useful for ranking under capital rationing (especially when projects are divisible).
Ranking conflict	A situation where different metrics (such as NPV versus IRR or PI) recommend different choices, often due to differences in project scale or cash flow timing.
Real option	The right—but not the obligation—to make a future decision about a real asset (such as delaying, expanding, switching, or abandoning a project), representing managerial flexibility.
Replacement chain method	A method for unequal lives that repeats the shorter-life project until both alternatives share a common evaluation horizon (often the least common multiple of lives).
Scenario analysis	A risk analysis method that changes multiple assumptions together (best/base/worst) to evaluate how combined conditions affect NPV.
Sensitivity analysis	A risk analysis method that changes one assumption at a time (holding others constant) to identify which variables have the greatest impact on NPV.
Soft rationing	An internally imposed investment budget cap set by management (for planning discipline, risk limits, or leverage targets), even if external financing may be available.
Switching option	A real option allowing a firm to change inputs (such as materials or energy source) or outputs (product mix) as conditions change, potentially improving project value.
Terminal cash flow	The project’s final period cash flow, which may include salvage value, after-tax proceeds from asset sale, and recovery of net working capital.
Tornado chart	A chart (often from spreadsheet sensitivity analysis) that ranks variables by their impact on NPV; longer bars indicate greater influence on value.
Timing option (option to delay)	A real option to postpone an investment until uncertainty is reduced (for example, waiting for demand, regulatory clarity, or cost information), potentially increasing value by avoiding premature commitment.

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