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Budget and Budgetary Control

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complete details of capital budgeting

Ateeq HashmiSuivre

Student at BZU LAHORE à BZU LahorePublicité

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- Assignment: Corporate Finance Submitted to: Dr Bilal Aziz Submitted by: Ateeq ur rehman Roll No: 026 Date: 18-12-2015
- Capital Budgeting Introduction: The term Capital Budgeting refers to long term planning for proposed capital outlay and their financing. It includes raising long-term funds and their utilization. It may be defined as a firm's formal process of acquisition and investment of capital. It deals exclusively with investment proposals, which an essentially long term projects and is concerned with the allocation of firm's scarce financial resources among the available market opportunities. Capital budgeting: The process through which different projects are evaluated is known as capital budgeting. Capital budgeting is defined “as the firm’s formal process for the acquisition and investment of capital. It involves firm’s decisions to invest its current funds for addition, disposition, modification and replacement of fixed assets”. “Capital budgeting is long term planning for making and financing proposed capital outlays”- Charles T Horngreen “Capital budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern” – Lynch
- The main features of capital budgeting are a. potentially large anticipated benefits b. a relatively high degree of risk c. relatively long time period between the initial outlay and the anticipated return. - Oster Young Nature of capital budgeting: Capital expenditure plans involve a huge investment in fixed assets. Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn without sustaining a loss. Preparation of capital budget plans involve forecasting of several years profits in advance in order to judge the profitability of projects. It may be asserted that, decision regarding capital investment should be taken very carefully so that the future plans of the company are not affected adversely. Significance of capital budgeting: The success and failure of business mainly depends on how the available resources are being utilized. Main tool of financial management All types of capital budgeting decisions are exposed to risk and uncertainty. They are irreversible in nature. Capital rationing gives sufficient scope for the financial manager to evaluate different proposals and only viable project must be taken up for investments. Capital budgeting offers effective control on cost of capital expenditure projects. It helps the management to avoid over investment and under investment
- Capital budgeting process Capital budgeting process involves the following 1. Project generation: Generating the proposals for investment is the first step. The investment proposal may fall into one of the following categories: Proposals to add new product to the product line, Proposals to expand production capacity in existing lines Proposals to reduce the cost of the output of the existing products without altering the scale of operation. Sales campaigning, trade fairs people in the industry, R and D institutes, conferences and seminars will offer wide variety of innovations on capital assets for investment. 2. Project Evaluation: It involves two steps Estimation of benefits and costs: The benefits and costs are measured in terms of cash flows. The estimation of the cash inflows and cash outflows mainly depends on future uncertainties. The risk associated with each project must be carefully analyzed and sufficient provision must be made for covering the different types of risks.
- Selection of appropriate criteria to judge the desirability of the project: It must be consistent with the firm’s objective of maximizing its market value. The technique of time value of money may come as a handy tool in evaluation such proposals. 3. Project Selection: No standard administrative procedure can be laid down for approving the investment proposal. The screening and selection procedures are different from firm to firm. 4. Project Evaluation: Once the proposal for capital expenditure is finalized, it is the duty of the finance manager to explore the different alternatives available for acquiring the funds. He has to prepare capital budget. Sufficient care must be taken to reduce the average cost of funds. He has to prepare periodical reports and must seek prior permission from the top management. Systematic procedure should be developed to review the performance of projects during their lifetime and after completion. 5. The follow up: Comparison of actual performance with original estimates not only ensures better forecasting but also helps in sharpening the techniques for improving future forecasts.
- Factors influencing capital budgeting The primary factors that influence a company's capital-structure decision are: 1. Business Risk Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio. As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad. 2. Company's Tax Exposure Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive becausethe tax deductibility of the debt payments protects someincome from taxes. 3. Financial Flexibility This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debtlevel, the more financial flexibility a company has.
- The airline industry is a good example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubtthe airline's ability to service its existing debt when it has new debtloaded on top. 4. Management Style Management styles range from aggressive to conservative. The more conservative a management's approachis, the less inclined it is to use debtto increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS). 5. Growth Rate Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate. More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cashflow, which can be used to finance projects when they arise. 6. Market Conditions Market conditions can have a significant impact on a company's capital-structure condition. Supposea firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.
- Methods of capital budgeting Traditional methods Payback period Accounting rate of return method Discounted cash flow methods Net present value method Profitability index method Internal rate of return Payback period method: Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques. Formula The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate payback period is: Payback Period = Initial Investment Cash Inflow per Period
- When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period: In the above formula: A is the last period with a negative cumulative cash flow; B is the absolute value of cumulative cash flow at the end of the period A; C is the total cash flow during the period after A Both of the above situations are applied in the following examples. Decision Rule Accept the project only if it’s payback period is LESS than the target payback period. Example 1: Even Cash Flows Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year for 7 years. Calculate the payback period of the project. Solution Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years Payback Period = A + B C
- Example 2: Uneven Cash Flows Company C is planning to undertake another project requiring initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project. Solution (Cash flows in millions) Cumulative Year Cash Flow cash flow 0 (50) (50) 1 10 (40) 2 13 (27) 3 16 (11) 4 19 8 5 22 30 Payback Period = 3 + (|-$11M| ÷ $19M) = 3 + ($11M ÷ $19M) ≈ 3 + 0.58 ≈ 3.58 years
- Why Use the Payback Method? It’s quick and easy to apply Serves as a rough screening device Disadvantages of payback method: It is based on principle of rule of thumb, Does not recognize importance of time value of money, Does not consider profitability of economic life of project, Does not recognize pattern of cash flows, Does not reflect all the relevant dimensions of profitability. Example: Assume that two gas stations are for sale with the following cash flows: According to the payback period, when given the choice between two mutually exclusive projects, Gas Station B should be selected. Although bothgas stations costthe same, Gas Station B has a payback period of one year, whereas Gas Station A will payback in roughly one and half years.
- Accounting Rate of Return method: It considers the earnings of the project of the economic life. This method is based on conventional accounting concepts. The rate of return is expressed as percentage of the earnings of the investment in a particular project. This method has been introduced to overcome the disadvantage of payback period. The profits under this method are calculated as profit after depreciation and tax of the entire life of the project. This method of ARR is not commonly accepted in assessing the profitability of capital expenditure. Because the method does to consider the heavy cash inflow during the project period as the earnings with be averaged. The cash flow advantage derived by adopting different kinds of depreciation is also not considered in this method. Formula Accounting Rate of Return is calculated using the following formula: ARR = Average Accounting Profit Average Investment Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.
- Decision Rule Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR. Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate of return assuming that there are no other expenses on the project. Solution Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years Annual Depreciation = ($130,000 − $10,500) ÷ 6= $19,917 Average Accounting Income = $32,000 − $19,917 = $12,083 Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3% Accept or Reject Criterion: Under the method, all project, having Accounting Rate of return higher than the minimum rate establishment by management will be considered and those having ARR less than the pre-determined rate. This method ranks a Project as number one, if it has highest ARR, and lowest rank is assigned to the project with the lowest ARR.
- Merits 1. It is very simple to understand and use. 2. This method takes into account saving over the entire economic life of the project. Therefore, it provides a better means of comparison of project than the payback period. 3. This method through the concept of "net earnings" ensures a compensation of expected profitability of the projects and 4. It can readily be calculated by using the accounting data. Demerits 1. It ignores time value of money. 2. It does not consider the length of life of the projects. 3. It is not consistent with the firm's objective of maximizing the market value of shares. 4. It ignores the fact that the profits earned can be reinvested. Discounted cash flow method: Time adjusted technique is an improvement over pay back method and ARR. An investment is essentially out flow of funds aiming at fair percentage of return in future. The presence of time as a factor in investment is fundamental for the purpose of evaluating investment. Time is a crucial factor, because, the real value of money fluctuates over a period of time. A rupee received today has more value than a rupee received tomorrow. In evaluating investment projects it is important to consider the timing of returns on investment. Discounted cash flow technique takes into account both the interest factor and the return after the payback 'period
- Discounted cash flow technique involves the following steps: Calculation of cash inflow and out flows over the entire life of the asset. Discounting the cash flows by a discount factor Aggregating the discounted cash inflows and comparing the total so obtained with the discounted out flows. Net present value method It recognizes the impact of time value of money. It is considered as the best method of evaluating the capital investment proposal. It is widely used in practice. The cash inflow to be received at different period of time will be discounted at a particular discount rate. The present values of the cash inflow are compared with the original investment. The difference between the two will be used for accept or reject criteria. If the different yields (+) positive value, the proposal is selected for investment. If the difference shows (-) negative values, it will be rejected. Formula: NPV = ∑ {Net Period Cash Flow/(1+R)^T} - Initial Investment Where R is the rate of return and T is the number of time periods. Advantages: 1. It recognizes the time value of money. 2. It considers the cash inflow of the entire project. 3. It estimates the present value of their cash inflows by using a discount rate equal to the cost of capital. 4. It is consistent with the objective of maximizing the welfare of owners.
- Disadvantages: 1. It is very difficult to find and understand the concept of cost of capital 2. It may not give reliable answers when dealing with alternative projects under the conditions of unequal lives of project Example of Net present Value: As was mentioned earlier, the payback period is a very basic capital budgeting decision tool that ignores the timing of cash flows. Since most capital investment projects have a life span of many years, a shorter payback period may not necessarily be the best project. Consider the gas station example above under the NPV method, and a discount rate of 10%: NPVgas station A = $100,000/(1+.10)2 - $50,000 = $32,644 NPVgas station B = $50,000/(1+.10) + $25,000/(1+.10)2 - $50,000 = $16,115 In our gas station example, the net present value tool illustrates the limitations of the payback period. Under the payback period, the decision would have been to pick gas station B because it had the shorter payback period. Under the NPV criteria, however, the decision favors gas station A, as it has the higher net present value. In this particular case, the NPV of gas station A is more than twice that of gas station B, which implies that gas station A is a vastly better investment project to undertake.
- Profitability Index (PI): Method: Note: PI should always be expressed as a positive number. If PI ≥ 1, then accept the real investment project; otherwise, reject it. Example of profitability index: Initial investment required: $100,000 Opportunity cost of capital: 15% The PI is … Year Cash Revenues less Expenses after tax 1 $20,000 2-9 $40,000 10 $10,000 InvestmentInitial PV PI investmentinitialafter theflowsCash
- PI: Strengths and Weaknesses: Strengths 1. PI number is easy to interpret: shows how many $ (in PV terms) you get back per $ invested. 2. Acceptance criteria are generally consistent with shareholder wealth maximization. 3. Relatively straightforward to calculate. 4. Useful when there is capital rationing. Weaknesses 1. Requires knowledge of finance to use. 2. It is possible that PI cannot be used if the initial cash flow is an inflow. 3. Method needs to be adjusted when there are mutually exclusive projects. Internal Rate of Return It is that rate at which the sum of discounted cash inflows equals the sum of Discounted cash outflows. It is the rate at which the net present value of the investment is zero. It is the rate of discount which reduces the NPV of an investment to zero. It is called internal rate because it depends mainly on the outlay and proceeds associated with the project and not on any rate determined outside the investment.
- Merits of IRR method: It consider the time value of money Calculation of cost of capital is not a prerequisite for adopting IRR IRR attempts to find the maximum rate of interest at which funds invested in the project could be repaid out of the cash inflows arising from the project. It is not in conflict with the concept of maximizing the welfare of the equity shareholders. It considers cash inflows throughout the life of the project. Demerits of IRR method: Computation of IRR is tedious and difficult to understand Both NPV and IRR assume that the cash inflows can be reinvested at the discounting rate in the new projects. However, reinvestment of funds at the cut off rate is more appropriate than at the IRR. IT may give results inconsistent with NPV method. This is especially true in case of mutually exclusive project. Internal Rate of Return: The internal rate of return (IRR) method can perhaps be the more complicated and subjective of the three capital budgeting decision tools. Similar to the NPV, the IRR accounts for the time value of money. It is useful here to repeat the definition of the IRR:
- The IRR of any project is the rate of return that sets the NPV of a project zero. Since the general NPV rule is to only pick projects with an NPV greater than zero with the highest net present value, the internal rate of return, by definition, is the breakeven interest rate. In other words, the IRR decision criteria conceptually obvious: Choose projects with an IRR that is greater than the cost of financing This rule is easy to understand: if your cost of capital is 10%, projects with an internal rate of return of 8% would destroy value, while projects with an internal rate of return of 15% with increase value. While it's conceptually simple to understand the internal rate of return process, calculating IRR can be a bit tricky. The calculation of a project's IRR is essentially a trial and error one. Consider the following example of a project with the following cash flows: There is no simple formula to calculate the IRR. It's either done by trial and error or a financial calculator. Remember, however, that the IRR is that rate where NPV is equal to zero; the equation would be set up like this: CF0 + CF1/(1+IRR) + CF2/(1+IRR)2 + CF3/(1+IRR)3 = 0, or -$1,000+ $100/(1+IRR) + $600/(1+IRR)2 + $800/(1+IRR)3 = 0 Believe or not, from here the next step is to guess a number for IRR, plug in and see if it equals zero. When IRR = 20%, or .20, the result is a number greater than zero (you can try it yourself, just enter "0.20" in place of "IRR." Performing a trial and error calculation here would be too cumbersome but it's very simple and good practice, to try it yourself).
- Thus 20% is too big a number. The next step would be to try a lower number. When IRR = 17%, the NPV is less than zero, so that IRR is too low. The IRR of this particular project is 18.1%. That is the interest where the NPV of the above project is zero. Plug it in and you should get zero or an insignificantly lower number that equates to zero. Thus, if the cost of financing the above the project is below 18.1%, the project creates value under the IRR calculation; if the cost of financing is greater than 18.1%, the project will destroy value. Just as is the case with the payback method and NPV, the IRR decision will not always agree with the NPV decision in mutually-exclusive projects. Again, this has to do with initial cash flow outlay and timing of future cash flows. However, in the end, despite the its flaws, percentages are more intuitive and useful in business, thus rendering value to the IRR method. Capital Budgeting conclusion: All for-profit business seemingly exist on the mandate of maximizing shareholder, or owner, value. A business is essentially a series of transactions that aim at generating greater revenue and profits. The capital budgeting process, or the methods employed by a company to invest in activities to generate additional value, is a dynamic process, to say the least. In a way, a business is nothing more than a series of many capital budgeting decisions. Decisions to hire a new CEO, negotiate contracts, maintain efficient operations, compete in the mergers and acquisitions arena, among others, are all capital budgeting decisions, in one way or another.
- Even decisions to reduce employees, shut down a division or the sale of part or all the company are capital budgeting decisions. Businesses are often observed being sold under the mandate of maximizing shareholder value. Whether minor or major, all business decisions involve an accounting of costs versus benefits. In a way, that's the essence of the capital budgeting process. Shareholders put their trust in management to constantly assess the costs versus benefits – the risk versus the reward – of their corporate actions. When a CEO is fired, it's often because a company has failed to create shareholder value. Put another way, which CEO or executive has failed to successfully engage in value- creating projects; the capital budgeting process under that CEO was ineffective. Understanding the capital budgeting process is not only important from an intellectual standpoint, but vital to understanding how a business can and will create future value. The world's greatest executives – Sam Walton of Wal-Mart, Roberto Goizueta of Coca Cola, Warren Buffett at Berkshire Hathaway, Jack Welch at General Electric – have a long history of making value creating decisions. These executives got capital budgeting process right. Individual investors also benefit from the capital budgeting process. Investing in a company's stock is much like investing in a project. At a given share price, investors ought to be able to figure out if that share price is below the intrinsic value of those shares. One determines the intrinsic value by conducting a discounted cash flow analysis, essentially finding the net present value of that company. Being able to seek out undervalued investments is clearly the ultimate objective for investors and corporate executives. In one form or another, the capital budgeting process is the set of tools that facilitates that value seeking process.

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