3.8 and 3.9 Investment Appraisal Budgets Terms

Accounting rate of return (ARR)

Also referred to as the average rate of return, this method of investment appraisal calculates the average annual profit of an investment project expressed as a percentage of the amount of invested.

Capital expenditure

A business organization's spending on the purchase or acquisition of fixed assets, e.g. spending on buildings (premises), machinery, equipment and tools.

Cumulative net cash flow

The sum of an investment project's net cash flows for a particular year plus the net cash flows of all previous years.

Discount rate

Also known as a discount factor, this is the figure used to reduce the future value of money. It is used to establish the present value of cash that is yet to be received by the business.

Discounted cash flow

This method of investment appraisal uses a discount rate (the inverse of compound interest) to reduce the value of money received in future years because money loses its value over time.

Investment

Capital expenditure with the intention of a financial return on this spending at some point in the future.

Investment appraisal

The formal process of quantifying the financial risks of an investment decision, in order to establish whether the expenditure can be justified from a financial perspective.

Net present value (NPV)

A method of investment appraisal that calculates the real value (rather than the absolute value) of an investment project by discounting (adjusting) the actual value of money received in the future.

Payback period (PBP)

The investment appraisal method that considers the time it takes for the amount of money invested in a project to be repaid using the proceeds generated from the investment.

Principal

The principal refers to the capital outlay or the original amount spent on an investment project.

Qualitative investment appraisal

Method of investment appraisal used to determine whether a project is worth investing in by using non-numerical techniques, e.g., whether the project aligns with the organization's mission.

Quantitative investment appraisal

Method of investment appraisal used to determine whether an investment project is worthwhile based on financial analysis, namely, PBP, ARR, and NPV.

Adverse variance

This discrepancy in the budget occurs when profit is lower than expected, due to costs being higher than expected and/or revenues being lower than predicted.

Budget

A detailed financial plan for the future, usually involving the expected costs and revenues or a cash flow forecast, for a pre-determined period of time.

Budgetary control

The financial methods used to attempt to balance actual outcomes with budgeted outcomes. This is achieved by systematic observations and corrective measures to minimize variances.

Cost centre

A section or division of a business that has responsibility for its own operational costs. It is held accountable for its departmental expenditure.

Favourable variance

This discrepancy in the budget occurs when profits are higher than expected, due to lower than expected costs and/or higher than predicted revenues.

Organization by function

Arranging the different cost centres of a business based on different functional departments of the organization.

Organization by geography

Arranging the different cost centres of a business based on the location of its operations domestically and/or overseas.

Organization by product

Arranging the different cost centres of a business based on what it produces, i.e. its range of different goods and/or services.

Profit

Refers to the positive difference between a firm’s total revenues and its total costs for any given period of time.

Profit centre

A section or division of a business that has responsibility for both costs and revenues generated within the department. It is held accountable for the amount of profit generated.

Variance

Refers to a discrepancy between the planned (budgeted) item of expenditure or revenue and the actual amount.

Variance analysis

This is the management process of comparing planned and actual costs and revenues, in order to measure and compare the degree of budgetary success.

Zero budgeting

A method of budgeting that requires all budget holders to justify each dollar of spending subject to management approved before the funds are released.