Communicating Capital Budgeting Decisions
Expert-defined terms from the Advanced Certificate in Budgeting For Capital Expenditures course at London School of Planning and Management. Free to read, free to share, paired with a professional course.
Accounting Rate of Return (ARR) is a method used to evaluate investment projects… #
Related terms include Return on Investment (ROI) and Residual Value. The ARR is calculated by dividing the average annual net income by the initial investment, discounted cash flow methods are not used in this approach. For example, a company is considering a project with an initial investment of $100,000 and expected annual net income of $15,000, the ARR would be 15%.
Activity #
Based Budgeting (ABB) is an approach to budgeting that focuses on the activities and costs associated with a project or organization, cost drivers are identified and used to allocate resources. Related terms include Activity-Based Costing (ABC) and Zero-Based Budgeting. ABB involves identifying the activities that drive costs and allocating resources accordingly, value is created by focusing on the activities that add value to the organization. For example, a company that produces widgets may identify the activities of production, marketing, and distribution as the key drivers of costs.
Amortization is the process of allocating the cost of an intangible asset over i… #
Related terms include Depreciation and Intangible Assets. Amortization is calculated by dividing the cost of the intangible asset by its useful life, straight-line method is commonly used. For example, a company purchases a patent for $100,000 with a useful life of 10 years, the annual amortization would be $10,000.
Avoidable Costs are costs that can be eliminated or reduced if a project or acti… #
Related terms include Sunk Costs and Opportunity Costs. Avoidable costs are relevant to decision-making as they can be saved or avoided, cost savings can be achieved by eliminating or reducing avoidable costs. For example, a company is considering a project that requires a new machine, the cost of the machine is an avoidable cost as it can be saved if the project is not undertaken.
Break #
Even Analysis is a method used to determine the point at which a project or activity will generate enough revenue to cover its costs, fixed costs and variable costs are used in this calculation. Related terms include Contribution Margin and Margin of Safety. Break-even analysis involves calculating the break-even point by dividing the fixed costs by the contribution margin, sales revenue is used to cover the costs. For example, a company has fixed costs of $100,000 and a contribution margin of 20%, the break-even point would be $500,000 in sales revenue.
Budgeting is the process of planning and controlling the financial resources of… #
Related terms include Capital Budgeting and Financial Planning. Budgeting involves establishing financial goals and objectives, allocating resources, and monitoring and controlling expenditures. For example, a company may establish a budget for the upcoming year, including projected revenues and expenditures.
Capital Budgeting is the process of evaluating and selecting investment projects… #
Related terms include Net Present Value (NPV) and Internal Rate of Return (IRR). Capital budgeting involves evaluating the expected cash flows and risks of a project, cost of capital is used to discount the cash flows. For example, a company is considering a project with an initial investment of $100,000 and expected annual cash flows of $20,000, the NPV would be calculated using the cost of capital.
Capital Expenditure is an investment in a tangible or intangible asset that is e… #
Related terms include Depreciation and Amortization. Capital expenditure involves investing in assets such as property, plant, and equipment, intangible assets such as patents and copyrights. For example, a company purchases a new machine for $100,000, the machine is expected to generate benefits over a period of 5 years.
Cash Flow is the movement of money into or out of an organization, inflows</b… #
Cash flow involves calculating the expected inflows and outflows of cash, discounted cash flow methods are commonly used. For example, a company expects to receive $100,000 in cash inflows and pay $50,000 in cash outflows, the net cash flow would be $50,000.
Cost #
Benefit Analysis is a method used to evaluate the costs and benefits of a project or activity, costs and benefits are quantified and compared. Related terms include Cost-Effectiveness Analysis and Break-Even Analysis. Cost-benefit analysis involves calculating the expected costs and benefits of a project, net present value is used to evaluate the project. For example, a company is considering a project with expected costs of $100,000 and expected benefits of $150,000, the net present value would be $50,000.
Cost of Capital is the cost of financing a project or activity, debt and… #
Related terms include Weighted Average Cost of Capital (WACC) and Capital Asset Pricing Model (CAPM). Cost of capital involves calculating the cost of debt and equity, weighted average cost of capital is used to evaluate projects. For example, a company has a cost of debt of 10% and a cost of equity of 15%, the weighted average cost of capital would be 12%.
Decision Tree is a graphical representation of the possible outcomes of a decisi… #
Related terms include Expected Monetary Value (EMV) and Sensitivity Analysis. Decision tree involves calculating the expected value of each outcome, probability of each outcome is used to calculate the expected value. For example, a company is considering a project with two possible outcomes, a decision tree would be used to evaluate the expected value of each outcome.
Depreciation is the process of allocating the cost of a tangible asset over its… #
Related terms include Amortization and Intangible Assets. Depreciation involves calculating the annual depreciation expense, useful life of the asset is used to calculate the depreciation. For example, a company purchases a machine for $100,000 with a useful life of 5 years, the annual depreciation expense would be $10,000.
Discounted Cash Flow (DCF) is a method used to evaluate the expected cash flows… #
DCF involves calculating the expected cash flows and discounting them using the cost of capital, time value of money is used to calculate the present value. For example, a company expects to receive $100,000 in cash flows over a period of 5 years, the present value would be calculated using the cost of capital.
Economic Value Added (EVA) is a measure of the economic value created by a proje… #
EVA involves calculating the NOPAT and subtracting the cost of capital, economic value is created when the NOPAT exceeds the cost of capital. For example, a company has a NOPAT of $100,000 and a cost of capital of $50,000, the EVA would be $50,000.
Financial Planning is the process of establishing financial goals and objectives… #
Related terms include Budgeting and Capital Budgeting. Financial planning involves establishing a financial plan, strategic planning is used to achieve the financial goals. For example, a company may establish a financial plan to achieve a return on investment of 15%.
Internal Rate of Return (IRR) is a method used to evaluate the expected return o… #
Related terms include Net Present Value (NPV) and Cost of Capital. IRR involves calculating the expected cash flows and discounting them using the cost of capital, internal rate of return is the rate at which the NPV equals zero. For example, a company expects to receive $100,000 in cash flows over a period of 5 years, the IRR would be calculated using the cost of capital.
Intangible Assets are non #
physical assets that have value to an organization, patents and copyrights are examples of intangible assets. Related terms include Amortization and Depreciation. Intangible assets involve investing in assets such as patents, copyrights, and trademarks, amortization is used to allocate the cost of the asset. For example, a company purchases a patent for $100,000, the patent is expected to generate benefits over a period of 10 years.
Margin of Safety is the difference between the expected sales revenue and the br… #
Related terms include Break-Even Analysis and Contribution Margin. Margin of safety involves calculating the expected sales revenue and subtracting the break-even point, safety margin is the difference between the expected sales revenue and the break-even point. For example, a company has a break-even point of $500,000 and expected sales revenue of $750,000, the margin of safety would be $250,000.
Net Present Value (NPV) is a method used to evaluate the expected cash flows of… #
Related terms include Internal Rate of Return (IRR) and Cost of Capital. NPV involves calculating the expected cash flows and discounting them using the cost of capital, net present value is the difference between the present value of the cash inflows and the present value of the cash outflows. For example, a company expects to receive $100,000 in cash flows over a period of 5 years, the NPV would be calculated using the cost of capital.
Operating Budget is a budget that outlines the expected revenues and expenditure… #
Related terms include Capital Budget and Financial Planning. Operating budget involves establishing a budget for the upcoming year, projected revenues and expenditures are used to establish the budget. For example, a company may establish an operating budget for the upcoming year, including projected revenues and expenditures.
Opportunity Cost is the cost of choosing one option over another, alternative… #
Related terms include Sunk Costs and Avoidable Costs. Opportunity cost involves evaluating the alternative options and choosing the best option, cost of choosing one option over another is the opportunity cost. For example, a company is considering two projects, the opportunity cost of choosing one project over the other is the expected return of the other project.
Payback Period is the time it takes for a project or activity to generate enough… #
Payback period involves calculating the expected cash flows and dividing the initial investment by the annual cash flows, time it takes to recover the initial investment is the payback period. For example, a company expects to receive $20,000 in annual cash flows and has an initial investment of $100,000, the payback period would be 5 years.
Return on Investment (ROI) is a measure of the return generated by a project or… #
ROI involves calculating the net income and dividing it by the initial investment, return on investment is the ratio of net income to initial investment. For example, a company has a net income of $50,000 and an initial investment of $100,000, the ROI would be 50%.
Risk Analysis is the process of evaluating the risks associated with a project o… #
Related terms include Sensitivity Analysis and Decision Tree. Risk analysis involves evaluating the possible risks and calculating the expected value of each risk, probability of each risk is used to calculate the expected value. For example, a company is considering a project with two possible outcomes, a risk analysis would be used to evaluate the risks associated with each outcome.
Sensitivity Analysis is a method used to evaluate the sensitivity of a project o… #
Related terms include Risk Analysis and Decision Tree. Sensitivity analysis involves changing the variables and calculating the impact on the project, sensitivity of the project to changes in assumptions is evaluated. For example, a company is considering a project with an expected return of 15%, a sensitivity analysis would be used to evaluate the impact of a change in the expected return.
Sunk Costs are costs that have already been incurred and cannot be recovered, <b… #
Related terms include Avoidable Costs and Opportunity Costs. Sunk costs involve costs that have already been incurred, irrelevant to decision-making as they cannot be changed. For example, a company has already incurred costs of $100,000 on a project, the sunk costs are irrelevant to the decision to continue or abandon the project.
Time Value of Money is the concept that money has a time value, present v… #
Time value of money involves calculating the present value of expected cash flows, discounted cash flow methods are commonly used.
Weighted Average Cost of Capital (WACC) is a method used to calculate the cost o… #
Related terms include Cost of Capital and Capital Asset Pricing Model (CAPM). WACC involves calculating the cost of debt and equity, weighted average cost of capital is used to evaluate projects. For example, a company has a cost of debt of 10% and a cost of equity of 15%, the WACC would be 12%.
Zero #
Based Budgeting is an approach to budgeting that involves justifying every dollar of expenditure, cost drivers are identified and used to allocate resources. Related terms include Activity-Based Budgeting (ABB) and Financial Planning. Zero-based budgeting involves justifying every dollar of expenditure, value is created by focusing on the activities that add value to the organization. For example, a company that produces widgets may identify the activities of production, marketing, and distribution as the key drivers of costs, zero-based budgeting would be used to justify every dollar of expenditure.