Economic Project Evaluation: Key Financial Terms
Cost & Value Concepts
Annual Equivalent Cost (AEC)
When only costs are involved, the Annual Equivalent Cost (AEC) method is applied.
Capital Recovery Cost
Owning equipment involves two transactions: (1) its initial cost (P) and (2) its salvage value (S).
Salvage Value
The asset’s value at the end of its useful life. It is the amount recovered through sale, trade-in, or salvage, net of all costs incurred for disposal and restoring the site to its original condition if required.
Cost Basis
Represents the total cost claimed as an expense over an asset’s life; includes the initial cost of an asset and all other incidental expenses such as freight and installation.
Matching Concept
A fraction of the cost of an asset is chargeable as an expense in each accounting period.
Investment & Project Types
Simple Investment
A project with only one sign change in its net cash flow series.
Non-Simple Investment
An investment in which more than one sign change occurs in the net cash flow series.
Service Projects
Projects whose revenues do not depend on the choice of alternative.
Revenue Projects
Projects whose revenues depend on the choice of alternatives.
Project Analysis & Planning
Analysis Period
The time span over which the economic effects of an investment will be evaluated.
Infinite Planning Horizon
Used when we are unable to predict when the activity under consideration will be terminated.
Finite Planning Horizon
Used when we have a definite and predictable duration for a project. Often represents a more realistic replacement policy.
Benefit-Cost Analysis
Commonly used to evaluate public projects.
Primary Benefits
A benefit directly attributable to a project. Example: Building a highway facilitates traffic and lowers goods transportation costs.
Secondary Benefits
A benefit indirectly attributable to a project. Example: The highway brings business to the area (e.g., hotels, gas stations).
Rates of Return & Discounting
Rate of Return (ROR)
The interest rate earned on the unpaid balance of an amortized loan.
Internal Rate of Return (IRR)
The interest rate earned on the unrecovered project balance of an investment such that, when the project terminates, the unrecovered project balance will be zero.
Social Discount Rate
The discount rate percentage used to compute the Net Present Value or evaluate the Internal Rate of Return for projects that benefit society. It is equivalent to the MARR (Minimum Acceptable Rate of Return) in the private sector.
Market Interest Rate (i)
A rate which combines the effects of interest and inflation; used with actual dollar analysis.
Inflation-Free Interest Rate (i’)
A rate from which the effects of inflation have been removed; this rate is used with constant dollar analysis.
Depreciation & Asset Life
Physical Depreciation
A reduction in an asset’s capacity to perform its intended service due to physical impairment.
Functional Depreciation
Occurs as a result of changes in the organization or technology that decrease or eliminate the need for an asset.
Useful Life
An estimate of the duration over which an asset is expected to fulfill its intended service. It may be based on the physical longevity of the asset or its functionality.
Financial & Capital Concepts
Current (Actual) Dollars
Sometimes called inflated dollars because they carry the effect of inflation (decreased purchasing power).
Constant (Real) Dollars
Dollars that represent the purchasing power of a base year (inflation-free dollars).
Actual Dollars (An)
Dollars that reflect the inflation or deflation rate.
Constant Dollars (A’n)
Year 0 dollars.
Equity Financing
Capital coming from either retained earnings or funds raised from an issuance of stock.
Debt Financing
Money raised through loans or by an issuance of bonds.
Capital Structure: Target Debt Ratio
Well-managed firms establish a target capital structure and strive to maintain the debt ratio.
Capital Structure: Firm Financing
The means by which a firm is financed.
Flotation Costs
The costs associated with issuing new securities.