Integrating Budgets and Capital Investment Appraisal

Question: Discuss about the Integrating Budgets and Capital Investment Appraisal? Answer: Introduction Need for Budgeting Budgeting is a process of creating a plan of how the money will be spent. It ensures that the company has enough cash for its business activities and helps in keeping a company out of debt. Through budgeting, a company can avoid wasteful expenditures, quickly adapt to the changing financial conditions and therefore, achieve its financial goals. It helps in breaking down the expenses and helps in knowing exactly how a companys revenues and expenses will be managed. Process of Budgeting The various steps included in budgeting are as given below: Setting the goals the first and foremost step is to set the financial goals for the company. Different companies may have different financial goals like earning a required percentage of profit, breaking even, reducing debt, growth and expansion etc. depending on these goals, the company prepares its future budgets which will ultimately fulfil these goals. The goals can be short term, medium term or long term. Source of Finance the second step is decide on the sources of finance which includes own capital or borrowings. Depending on the financial goals, the company chooses its source of finance. Like if a makes long term goal to expand its business, then it may have to undertake a significant amount of loan apart from own capital. Projection of Revenue and costs the revenue projections are based on historical figures and expected growth. The fixed costs are more or less known and can be easily included in the budget. The variable costs can be controlled and should be properly budgeted. Target profit margin every business operates to make profits, hence, target profit margins should be decided and included in the budget. Board Approval the prepared budget should be presented to the board for approval and the board should keep a check if the performance is as per the budget. Budget review the budget should be reviewed on a periodic basis for actual performance versus the budgeted. Any variance should be found and be dealt with. Limitations of Budget Its not always possible to accurately determine revenue and expenses Involves lot of time and paper work and is costly Takes away the flexibility of the management It may sometimes lead to excessive spending as a department tries to utilize all the amount allocated to it It may lead to inter department conflicts in an organization Budget Preparation of the Hotel John wants to start a hotel with 20, 00,000. He has provided with the investment details that needs to be undertaken for starting the hotel which includes purchase of fixed assets like property, furniture, kitchen equipment, laundry equipment and gym equipment. Also some investment will be made in working capital. John has provided details of expected revenue and expenses for the first six months starting from April to September 2016. On the basis of the information provided, financial statements including Income Statement and Balance Sheet have been prepared and a Cash Budget has also been prepared. The statements are presented below: Cash Budget of the Hotel for six months ending 30th September, 2016 Particulars April May June July August September Total Opening Cash Balance 1,25,000 1,27,430 1,42,415 1,63,745 1,98,440 2,40,965 1,25,000 Receipts Collection from customers 12,150 16,200 28,350 36,450 36,450 28,350 1,57,950 Collection from customers 28,350 37,800 66,150 85,050 85,050 3,02,400 Total receipts 12,150 44,550 66,150 1,02,600 1,21,500 1,13,400 4,60,350 Payments Direct Materials 1,620 2,160 3,780 4,860 4,860 3,780 21,060 Direct Materials 6,480 8,640 15,120 19,440 19,440 69,120 Labour cost 8,100 10,800 18,900 24,300 24,300 18,900 1,05,300 Overhead cost 10,125 13,500 23,625 30,375 30,375 1,08,000 Total Payments 9,720 29,565 44,820 67,905 78,975 72,495 3,03,480 Closing Cash Balance 1,27,430 1,42,415 1,63,745 1,98,440 2,40,965 2,81,870 2,81,870 Budgeted Income Statement for the Hotel for six months ending 30th September, 2016 April May June July August September Total Sales 40,500 54,000 94,500 1,21,500 1,21,500 94,500 5,26,500 Cost of goods sold Direct Materials 33,100 10,800 18,900 24,300 24,300 18,900 1,30,300 Labour 8,100 10,800 18,900 24,300 24,300 18,900 1,05,300 Overhead 10,125 13,500 23,625 30,375 30,375 23,625 1,31,625 Total COGS 51,325 35,100 61,425 78,975 78,975 61,425 3,67,225 Gross Profit -10,825 18,900 33,075 42,525 42,525 33,075 1,59,275 Depreciation 4,875 4,875 4,875 4,875 4,875 4,875 29,250 Net Income -15,700 14,025 28,200 37,650 37,650 28,200 1,30,025 The income statement suggests a favourable outcome of the business as the company will start earning profits from the 1st month itself and we can see that the profits are increasing every month on an average except May and September, however the total profits more than 10% of the total revenue. Budgeted Statement of Financial Position of the Hotel as on 30th September, 2016 Assets Amount Liabilities Amount Current Assets Current Liabilities Inventory 10,000 Payables 38,745 Cash 2,81,870 Receivables 66,150 Total Current Assets 3,58,020 Total Current Liabilities 38,745 Fixed Assets Owner's Equity Leasehold Property 16,00,000 Owners capital 20,00,000 Furniture and Fittings 1,50,000 Retained Earnings 1,30,025 Kitchen Equipment 50,000 Laundry Equipment 25,000 Gym Equipment 15,000 Total Property, plant Equipment 18,40,000 less depreciation -29,250 Total Fixed Asset 18,10,750 Total Owner's equity 21,30,025 Total Assets 21,68,770 Total Liabilities 21,68,770 The financial position of the company looks good as the current assets are more than the current liabilities and the company has no debts in their entire business operations. The company is in a very liquid position with an increased cash balance from 125000 to 281870. This is a good indicator of profitable business. Capital Budgeting Techniques Capital budgeting is a planning process of determining whether an investment proposal should be undertaken or not. In the above case, John wants to set up the hotel and wants to operate the same for 10 years. It is important to know whether investment undertaken for the hotel will be profitable or not i.e. the net cash flows from the investment will be enough to recover the initial investment or not. Capital budgeting discounts the future cash flows to bring it to the zero year so that we know the future cash flows discounted at current period are more than the initial investment or not. This process is undertaken to adjust for the effects of inflation and also the time value of money. The three most important capital budgeting techniques include Net Present Value (NPV), Payback period and Internal Rate of Return (IRR). NPV of the project Net present value is the difference between the cash outflows and cash inflows generated from the project. It is an effective tool since it takes into account the discounted cash flows to adjust for the uncertainties of the future cash flows. Year Net Cash Flow Proceeds from sale of hotel Total Cash Flow Present value factor PV of net cash flow 1 1,84,275 1,84,275 0.9345 1,72,204.99 2 1,89,803.25 1,89,803 0.8734 1,65,774.16 3 1,95,497.35 1,95,497 0.8163 1,59,584.48 4 2,01,362.27 2,01,362 0.7629 1,53,619.27 5 2,07,403.14 2,07,403 0.7129 1,47,857.70 6 2,13,625.23 2,13,625 0.6663 1,42,338.49 7 2,20,033.99 2,20,034 0.6227 1,37,015.16 8 2,26,635.01 2,26,635 0.582 1,31,901.57 9 2,33,434.06 2,33,434 0.5439 1,26,964.78 10 2,40,437.08 32,00,000.00 34,40,437 0.5083 17,48,774.17 Total PV of Cash Flows 30,86,034.78 Initial Investment 20,00,000.00 Net Present Value 10,86,034.78 The net cash flows are assumed to increase by 3% every year. Payback period Payback period is the time required by the project to recover its initial investment. Year Net Cash Inflow Cumulative net cash inflow 0 -20,00,000.00 -20,00,000.00 1 1,84,275 -18,15,725 2 1,89,803 -16,25,922 3 1,95,497 -14,30,424 4 2,01,362 -12,29,062 5 2,07,403 -10,21,659 6 2,13,625 -8,08,034 7 2,20,034 -5,88,000 8 2,26,635 -3,61,365 9 2,33,434 -1,27,931 10 34,40,437 33,12,506 Payback period = 9+ (-1, 27,931/34, 40,437) = 9.04 years Discounted Payback period Discounted payback period is the time required to recover the initial investment in terms of discounted cash flow. Year Net Cash Inflow Cumulative net cash inflow 0 -20,00,000.00 -20,00,000.00 1 1,72,204.99 -18,27,795 2 1,65,774.16 -16,62,021 3 1,59,584.48 -15,02,436 4 1,53,619.27 -13,48,817 5 1,47,857.70 -12,00,959 6 1,42,338.49 -10,58,621 7 1,37,015.16 -9,21,606 8 1,31,901.57 -7,89,704 9 1,26,964.78 -6,62,739 10 17,48,774.17 10,86,035 Discounted payback period = 9+ (6, 62,739/17, 48,774.17) = 9.38 years As per the capital budgeting techniques, a project with a positive NPV is acceptable as the cash inflows is more than the cash outflows. In the above case, the NPV is positive, hence the project is acceptable. With reference to the payback period, a project where the initial investment is recovered within the project period, the project becomes acceptable. In the above case, the initial investment is being recovered after 9 years but before 10 years. Even the discounted payback period where the cash inflows are discounted to the present year, is within 10 years, though it is more than the payback period, still the project becomes acceptable. References Pollitt, C. 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