FAS L4

Capital budget lists the investments that a company plans to undertake the coming year

capital budgeting process used to analyze alternative investments and decide which one to accept. begins with forecasts of the project's future consequences for the fimr

incremental earnings amount by which the firm's earnings are expected to change as a result of the investment decision

opportunity cost the value a resource could have provided in its best alternative use

project externalities an indirect effect on the project that may affect the profits or other business activities of the firm

cannibalization when sales of a new product displaces sales of an existing product

sunk costs cost that have been or will be paid regardless of the decision whether or not the investment is undertaken, are not included in the incremental earnings analysis

fixed overhead expenses should not be included in the calculation of incremental earnings, associated with activities that are not connected to a single business activity, but affect many different areas

earnings includes non-cash charges, for example depreciation but does NOT include the cost of capital investment

payables mature the credit the firm has received to its customers

receivables measure the total credit that the firm has extended to its customers

trade credit the difference in the net amount of the firm's capital that is consumed as a result of these credit transactions, or difference between receivables and payables

Break-even analysis level of an input - the level that causes the NPV of the investment to equal zero, for example IRR

Sensitivity analysis shows how the NPV varies with a change in one of the assumptions, holding the other assumptions constant

scenario analysis considers the effect on the NPV of simultaneously changing multiple assumptions

expected return a weighted average of the possible returns, where the weights correspond to the probabilities, the return we would earn on average if we could repeat the investment many times, the balancing point of the distribution

variance and standard deviation used to measure risk

variance the expected squared deviation from the mean, measure of how to "spread out" the distribution of the return

standard deviation the square root of the variance

efficient market hypothesis implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors

firm specific news good or bad news about an individual company

market-wide news news that affects all stocks, such as news about the economy

independent risks uncorrelated, affects a particular security

common risks perfectly correlated, affects all securities

market risk premium the reward investors expect to earn for holding a portfolio with a beta of 1

Capital Asset pricing model CAPM the most important method for estimating the cost of capital that is used in practice

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