Question

In this assignment assume you are a CFO of a small manufacturing company and the CEO wants your input the value of budgeting. Write a three page memo to the CEO explaining the purpose, basic components of the budget, and the benefits of a budget. As an appendix to your memo, discuss the capital budget process (purpose and value) and the various methods used to evaluate capital investment projects, including the pros and cons of each method. Include in your memo your recommendation to the CEO whether or not to prepare a budget, how long it should take and when it should begin.

Answer 1

A budget is a quantitative statement, prepared prior to a defined period of time, for the purpose of attaining a given objective. Budgets are prepared normally for achieving business goals and objectives, because policies are formulated to achieve the objectives and those are translated into quantitative and financial base.

Components of budget:

1. Organisational structure must be clearly identified and responsibility should be assigned to levels within the organisation.

2. Achievable objectives and reasonable targets should be prepared.

3. Budgets should be prepared for the future periods on the basis of expected course of actions and estimate of future certainty

4. Budgets should be updated for the events while establishing budgets as it is continuing process.

5. Budgets should be flexible and not rigid.

6. The whole organisation must be committed and accountable to budgeting

7. Budgets should be quantifiable and a master budget should be classified into various functional budgets

8. Budgets should be monitored on periodical basis by the managers and officers.

9. Variances from the standard yardsticks should be analysed and responsibility should be fixed.

Advantages of Budget Control

1. Budget targets at maximisation of profits and revenues through optimum utilisation of resources.

2. It is a technique for continuous monitoring of policies and objectives of the organisation as made under standard operating procedures

3. It helps in reducing the costs, thereby helps in better utilisation of funds of the organisation.

4. All the departments of the organisation are closely coordinated through establishment of plans resulting in smooth functioning of the organisation.

5. It facilitates analysis of variances, thereby identifying the areas where deficiencies occur and proper remedial action can be taken.

6. Budgets act as a motivating force to achieve the desired objective of the organisation.

7. It assists delegation of authority and is a perfect tool of responsibility and accountability

8. It helps in stabilizing the conditions in industries which face seasonal fluctuations.

9. It helps as a basis for internal audit.

10. It ensures adequacy of working capital to the organisation and makes the ratios intact and also aids in obtaining bank credit.

11. It aids in performance analysis and performance reporting system.

12. Budgets are forerunners of standard costs in the sense that they create necessary conditions to suit setting up of standard costs.

The CEO should prepare the budget. The preparation of budget should not be time consuming process. If the budget is prepared monthly than the budget should be prepared at the start of the month. And if the budget is prepared yearly than the budget should be prepared at the start of the year.

Capital Budget Process:

1. Creation of Project/Investment: Depending upon the nature of the firm, investment proposals can emanate from a variety of sources. Projects may be classified into five categories.

· New products or expansion of existing products.

· Replacement of equipment or buildings.

· Research and development.

· Exploration.

· Others like acquisition of a pollution control device etc.

Investment proposals should be generated for the productive employment of firm’s funds. However, a systematic procedure must be evolved for generating profitable proposals to keep the firm healthy.

2. Evaluation of the project/Investment: The evaluation of the project may be done in two steps. First the costs and benefits of the project are estimated in terms of cash flows and secondly the desirability of the project is judged by an appropriate criterion. It is important that the project must be evaluated without any prejudice on the part of the individual. While selecting a criterion to judge the desirability of the project, due consideration must be given to the market value of the firm.

3. Selection of the project/Investment: After evaluation of the project, the project with highest return should be selected. There is no hard and fast rule set for the purpose of selecting a project from many alternative projects. Normally the projects are screened at various levels. However, the final selection of the project vests with the top level management.

4. Execution of project/Investment: After selection of a project, the next step in capital budgeting process is to implement the project. Thus the funds are appropriated for capital expenditures. The funds are spent in accordance with appropriations made in the capital budget funds for the purpose of project execution should be spent only after seeking format permission for the controller. The follow – up comparison of actual performance with original estimates ensure better control.

Methods Used to Evaluate Capital Investment Project

1. Pay-back Period: It is the most popular and widely recognized traditional methods of evaluating the investment proposals. It can be defined as the number of years to recover the original capital invested in a project.

Pros:

· Easy to calculate

· The knowledge of payback period is useful in decision-making, the shorter the period better the project.

· Protection from loss due to obsolescence:

· Easily availability of information:

Cons:

· Failure in taking cash flows after payback period

· Not considering the time value of money

· Non-considering of interest factor

· Maximisation of market value not possible

· Failure in taking magnitude and timing of cash inflows

2. Accounting Rate of Return (ARR): This method uses accounting information as revealed by the financial statements, to measure the profitability of an investment project. The ARR is found out by dividing the average post-tax profit by the average investment. This technique uses the accounting information revealed by the financial statements to measure the profitability of an investment proposal. This method also helps the management to rank the proposal on the basis of ARR.

Accounting Rate of Return (ARR) = Original Investment/Average Net Income

Pros

· It is very simple to understand and calculate

· It can be readily computed with the help of the available accounting data

· It uses the entire stream of earnings to calculate the ARR.

Cons

· It is not based on cash flows generated by a project

· This method does not consider the objective of wealth maximization

· It ignore the length of the projects useful life

· If does not take into account the fact that the profile can be re-invested

· It ignores the time value of money.

3. Net Present Value (NPV) is a process of calculating the present value of a project’s cash flows, using the opportunity cost of capital as the discount rate, and finding out the net present value by subtracting the initial investment from the present value of cash flows. The net present value method is a classic method of evaluating the investment proposals. It is one of the methods of discounted cash flow techniques, which recognizes the importance of time value of money.

Pros:

· Consideration to total Cash Inflows

· Recognition to the Time Value of Money

· Changing Discount Rate

· Best decision criteria for Mutually Exclusive Projects

· Maximisation of the Shareholders Wealth

Cons:

· It is difficult to understand and use.

· The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of capital itself is difficult to understand and determine.

· It does not give solutions when the comparable projects are involved in different amounts of investment.

· It does not give correct answer to a question when alternative projects of limited funds are available, with unequal lives.

4. Profitability Index (PI) is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. According to Van Horne, the profitability Index of a project is “the ratio of the present value of future net cash inflows to the present value of cash outflows”

Pros:

· It takes into account the time value of money

· It helps to accept / reject investment proposal on the basis of value of the index.

· It is useful to rank the proposals on the basis of the highest /lowest value of the index.

· It takes into consideration the entire stream of cash flows generated during the life of the asset.

Cons

· It is somewhat difficult to compute.

· It is difficult to understand the analytical of the decision on the basis of profitability index.

5. Internal Rate of Return (IRR) Method is a discounted cash flow technique which takes account of the magnitude and timing of cash flows. The IRR is that discount rate which equates investment outlay with the present value of inflows received after a period of time.

Pros

· Consideration of Time of Money

· Consideration of total Cash Flows

· Maximising of shareholders’ wealth

· Provision for risk and uncertainty

· Elimination of pre-determined discount rate

Cons

· It is very difficult to understand

· It involves a very complicated computational work

· It may not give unique answer in all situations.

· The assumption of re-investment of cash flows may not be possible in practice.