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typical situation would concern, say, including the cost of a new canteen along with the cost

603

604 Glossary

of a new plant on the same site. If the canteen was required irrespective of the new plant it

should be shown as a separate investment.

Capital asset pricing model (CAPM)

An approach which allows the cost of equity to be calculated. The cost is calculated via a

straight line relationship between risk and required return. Under the CAPM, the cost of

equity is equal to the cost of a risk-free investment plus a factor referred to as the Greek letter

beta (Î²) times the average premium which is required by investors for investing in a typical

share. Î² is a function of the risk inherent in the equity which is not diversifiable by holding a

wide portfolio of investments.

Capital employed

An accounting term representing the sum of a companyâ€™s fixed assets and working capital. It

represents the money which has been invested in the so-called assets of a company. Note that

traditional accounting statements have to be restated in order to highlight this figure.

Capital investment (often shortened to capex)

The initial investment in a project which is required in order to build its physical assets.

Cash flow

The cash which a company generates in a period as measured by its change in cash. Note that

because cash holdings can be changed by financing activities such as borrowing money as

well as operational activities, cash flow is not as important as one might anticipate and is not

the key input into the so-called discounted cash flow model. The discounted cash flow model

is actually based on the so-called funds flow which is the generation of cash excluding any

financing effects.

Company as Î£ projects

A technique proposed in this book which estimates the accounting performance of a com-

pany that simply implements a series of projects all similar to the one under consideration.

Adjustments for growth, sunk costs and overheads can also be made with the aim being to

allow actual company performance to provide a reality check on claimed performance.

Components of value

This is a technique which involves describing the NPV of a project by reference to the sum of

the present value of the individual lines in the projectâ€™s cash flow model.

Continuous good surprises (CGS)

This is what quoted companies have to deliver to their shareholders if they are continually

to deliver to shareholders returns of above the cost of equity. It is a very tough challenge

and this is due to the way that the share price will already capture anticipated future per-

formance in todayâ€™s share price.

Cost of capital (CoC)

The average cost of the funds used by a company. The funds will usually comprise a mixture

of debt and equity. Our theories suggest that the main determinant of the cost of capital is the

risk associated with the use to which the funds are put. The cost of capital can be calculated

as the weighted average of the cost of funds raised through debt (referred to as the CoD) and

the cost of funds raised through equity (CoE).

605 Glossary

Cost of debt (CoD)

The cost of funds raised by a company as debt. This is the interest rate charged on the com-

panyâ€™s debt.

Cost of equity (CoE)

The cost of funds raised by a company as equity. Unlike the cost of debt, which is observable,

the cost of equity is not. It is deduced via various approaches, the most common of which

is called the capital asset pricing model (CAPM). Companies must seek to give the required

return to equity shareholders through a combination of dividends paid out plus growth in

the value of shares owned.

Credit rating agencies

These are companies whose business is assessing the potential risks taken by lenders when

they lend to companies. This service helps companies decide whether or not to lend to a com-

pany and also to assess what interest rate to charge.

Current assets

An accounting term referring to assets which will be held for less than a year. The main com-

ponents of current assets are receivables and inventories.

DCF return

Another name for a projectâ€™s internal rate of return (IRR). That is to say, the discount rate

which, when applied to a project, results in a zero NPV.

Debt

One of the two main sources of finance (the other is equity). Debt is characterised by the

requirement to pay interest and to repay the sum borrowed (called the principal). Debt can

be given many names including borrowing, gearing, leverage, a mortgage, an overdraft, a

bond or a note. Debt is a low-risk way of investing money but is high risk to the person or

company that borrows because failure to pay interest or repay the principal according to

the agreed schedule can allow the lender to force a company into liquidation.

Discounted cash flow (DCF)

A methodology which aids financial decision making by converting sums of money which

are anticipated to occur at different points in time into their equivalent in present value

terms. The methodology involves two components. These are cash flows generated through

the operational activities of the project under consideration and the appropriate discount

rate (or cost of capital). Cash flows caused by financing activities are excluded from the cal-

culation. The methodologyâ€™s alternative name, which is the economic value model, is empha-

sised in this book because it avoids this potential confusion concerning exactly what is to be

discounted.

Discounted payback (DP)

The point in time when a project first recovers its initial investment after allowing for the

effect of discounting. It is the point when the graph of cumulative present value first returns

to zero after the time below zero which is caused by the initial investment.

Discount rate

The interest rate which is used to convert a sum of money in one yearâ€™s time into its equiva-

lent now. Other names for this term are the cost of capital and the time value of money.

606 Glossary

Economic indicator

A means of characterising the projected financial performance of a project. This book sug-

gests use of four indicators which are net present value, internal rate of return, discounted

payback and investment efficiency.

Economic value model

A methodology which aids financial decision-making by converting sums of money which

are anticipated to occur at different points in time into their equivalent in present value terms.

The methodology involves two components. These are cash flows and the appropriate discount

rate (or cost of capital). The methodology is also referred to as discounted cash flow (DCF).

Equity

One of the two main sources of finance (the other is debt). Equity is characterised by the way

that it allows investors to take risks in return for the potential of higher rewards than when

investing in debt. Equity brings with it ownership rights such as a vote on the appointment

of directors.

Equity risk premium

The additional return over the risk-free rate which investors in equity require on average in

order to compensate them for taking the risks inherent in investing in a wide portfolio of

shares.

Expected value

The probability-weighted outcome. This is the sum of all of the possible outcomes times their

respective probability.

Fish diagram

A chart suggested in this book. The fish diagram shows both the traditional project view of

the value profile over time and also the market view of what a project is worth. With a typical

project the two lines on this chart will form the shape of a fish.

Five forces model

A structured way for considering the inherent profitability of any industry. The model was

proposed by Professor Michael Porter and suggests that different levels of profitability can

be explained by reference to: industry competitors; supplier power; buyer power; potential

entrants and the threat of substitutes.

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