Short Glossary regarding the quiz 2
Net present value (NPV), is how much an investment is worth throughout its lifetime, discounted to today's value. The formula for NPV is often used in investment banking and accounting to determine if an investment, project, or business will be profitable in the long run.
The profitability index (PI) is a measure of a project's or investment's attractiveness. The PI is calculated by dividing the present value of future expected cash flows by the initial investment amount in the project.
The equivalent annual annuity approach (EAA) is one of two methods used in capital budgeting to compare mutually exclusive projects with unequal lives. The EAA approach calculates the constant annual cash flow generated by a project over its lifespan if it was an annuity.
Equivalent annual cost (EAC) is the annual cost of owning, operating, and maintaining an asset over its entire life. Firms often use EAC for capital budgeting decisions, as it allows a company to compare the cost-effectiveness of various assets with unequal lifespans.
Both EAA and EAC are used to evaluate various projects with different investment years or service lives. EAA is calculated from the perspective of profitability, while EAC is considered from the perspective of cost.
The internal rate of return (IRR) is a financial metric used to assess the attractiveness of a particular investment opportunity. When you calculate the IRR for an investment, you are effectively estimating the rate of return of that investment after accounting for all of its projected cash flows together with the time value of money. When selecting among several alternative investments, the investor would then select the investment with the highest IRR, provided it is above the investor's minimum threshold. The main drawback of IRR is that it is heavily reliant on projections of future cash flows, which are notoriously difficult to predict.
The crossover rate (CoR) is the rate of return (alternatively called the weighted average cost of capital) at which the Net Present Values (NPV) of two (mutually exclusive) projects are equal. It represents the rate of return at which the net present value profile of one project intersects the net present value profile of another project.
The payback period (PP) is defined as the number of years required to recover the original cash investment. In other words, it is the period of time at the end of which a machine, facility, or other investment has produced sufficient net revenue to recover its investment costs.
The discounted payback period (DPP) is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money.