Question

Please define the capital budget including its purpose, contents, and budgeting process. Explain how the capital and operating budgets differ, and how they are linked. Define debt service and how it relates to the capital and operating budgets. Explain how capital budgets are funded, and how large capital projects are approved by the voters. What are "bonds" and why do they matter? What is the significance of a "bond" referendum? What defines a capital project? What are the major differences between a capital project and an operating budget item?

Answer 1

Capital Budgeting is a process used by companies to assess projects and investment by using their future generated cash flows, the required rate of return, and project lifetime to come to a decision. There are several methods used in this process like NPV, IRR, Payback-Period, Profitability Index, etc.

Capital budget repayment is generally done out of future cash flows generated by the projects, and generally this projects include the purchases of fixed assets or long-term assets. Whereas the project of the operational budget is for the activities which include day to day business of the firm is like buying, selling, and paying bills, so this is done on an annual basis or each year, unlike capital budgeting which is done less frequently.

But the purchase of fixed assets as projected by the capital budget will put an impact on the operational budget as the working capital will change with the addition of new assets. So they are linked in this manner.

Debt service is the cash required to cover the interest as well as the principal amount of payment by a firm. It basically shows the ability of a firm to repay both the components. So when a company approaches a banker for short-term or long-term loans they evaluate the DSCR ratio of the company and decide whether to lend or not. And if a loan is approved then at what rate it should be lent as DSCR also gives an idea about the risk status of the company.

Capital budgets can be funded by raising money through debt or equity or retained earnings or can be done using a combination of any. The approval of voters is essential once the financial feasibilty and profitability test is done.

Bonds are debt instruments that are used to raise capital for the company. They are the fixed obligations towards a company as there would be a coupon or interest payment on bonds (not in zero coupons bond) and face value payment at maturity. They have a tax advantage as the interest component provides a tax-shield to the company so they are important to the company.

Bond referendum is a voting process that gives voters the right to decide whether the company should be authorized to raise funds by issuing bonds. As bonds are fixed obligations so the shareholders should have the right to decide whether the company should go for additional financial burden or not. So, their opinion is valued by providing them the voting rights through a bond referendum.