BUDGETS AND EXPENDITURE OF CAPITAL

THE BASIC STEPS OF CAPITAL BUDGETING

Capital budgeting is the process of determining whether a big expenditure is in a
company's best interest. Here are the basics of capital budgeting and how it works.
Capital Budgeting Basics
A company undertakes capital budgeting in order to make the best decisions about
utilizing its limited capital. For example, if you are considering opening a distribution
center or investing in the development of a new product, capital budgeting will be
essential. It will help you decide if the proposed project or investment is actually worth it
in the long run.
Identify Potential Opportunities
The first step in the capital budgeting process is to identify the opportunities that you
have. Many times, there is more than one available path that your company could take.
You have to identify which projects you want to investigate further and which ones do
not make any sense for your company. If you overlook a viable option, it could end up
costing you quite a bit of money in the long term.
Evaluate Opportunities
Once you have identified the reasonable opportunities, you need to determine which ones
are the best. Look at them in relation to your overall business strategy and mission. See
which opportunities are actually realistic at the present time and which ones should be
put off for later.
Cash Flow
Next, you need to determine how much cash flow it would take to implement a given
project. You also need to estimate how much cash would be brought in by such a project.
This process is truly one of estimating--it takes a bit of guesswork. You need to try to be
as realistic as you can in this process. Do not use the best-case scenario for your numbers.
Most of the time, you need to use a fraction of that number to be realistic. If the project
takes off and the best-case scenario is reached, that is great. However, the odds of that
happening are not the best on new projects.
Select Projects
After you look at all of the possible projects, it is time to choose the right project mix for
your company. Evaluate all of the different projects separately on their own merits. You
need to come up with the right combination of projects that will work for your company
immediately. Choose only the projects that mesh with your company goals.
Implementation
Once the decisions have been made, it is time to implement the projects. Implementation
is not really a budgeting issue, but you will have to oversee everything to be sure it is
done correctly. After the project gets started, you will need to review everything to make
sure the finances still make sense.
Read more: http://www.finweb.com/financial-planning/the-basic-steps-of-capital-
budgeting.html#ixzz4imevaRZV

CONSIDERATIONS OF THE CAPITAL

When management encounters growth obstacles they can easily find themselves faced
with decisions that directly involve the possible acquisition of long-term assets with a
variety of funding options. The assets can be anything from equipment to technology.
Company leadership could be considering two main forms of investments: independent
investments, which upon implementation would not impact cash flows in other business
areas; or exclusive investments, which upon implementation will affect competing areas
of the business. There are unlimited variables to consider, but business leaders must
prioritize the most relevant elements for consideration in their respective markets, and
flip growth levers at the right time in order to progress effectively into the future.
1. Consider human capital. Always invest in your people, and enable their talents. The
ability of your people to create economic value, is overlooked far too much in some major
investment decisions, and the true cost of not considering your team may not show up in
financial statements until it is too late. Consider your peoples experience, knowledge,
and insights, as they are the organizational leaders who will likely be responsible for
driving the team through changes successfully that the proposed investment brings. What
good is an investment in new machinery or technology if your team is not prepared to
fully leverage those resources? Consider the impact on people upfront: identify any talent
or capability gaps, training needs, and plan an execution strategy that makes sense.
Company leadership must recognize the different functions of their business leaders,
share, effectively communicate, and consult investment information with those identified
leaders when making these critical decisions.
2. Consider calculating and forecasting payoff. Consider utilizing both the payback
period, and the accounting rate of return for investment payoff insights, both can help you
decide if you should move forward. The payback period will reveal the expected time
required for your business to recover from investments, while the accounting rate of
return can be useful to filter through investment opportunities and evaluating potential
impact on debt ratios, or rather, actual debt implications. The downside is that neither of
the aforementioned measures factor in the time value of money. Youre CPA, or financial
analysts should develop a discounting model that takes external drivers, and other
variables into consideration based on your business model and market space, as it is
valuable information to sizing up market opportunities and benchmarking with fiscal
competence. Predictable profitability is key, but management should not overlook
contribution to overall growth, and the strategic side of how the proposed investment will
position the future outlook of the business.
3. Consider requiring a certain rate of return and the value of time. Determine the
difference in your initial investment and the present value of future cash flows that you
are expecting, more commonly known as the Net Present Value (NPV). Once your team
has set a reasonable target (which is typically based of cost of capital), you can compute
the present value of expected investments and gain insights to cash flow implications. If
the present value of cash inflow is greater than outflows, than NPV is greater than zero,
thus profitable. But is it profitable enough to move forward? Can you do anything to make
this investment more profitable? Obviously, should the calculation be less than zero, and
deemed unlikely to be profitable you can start pumping the brakes on the investment,
unless it is perhaps tied to the long term strategic viability of your business. What about
your time? Time is the most valuable resource anyone has (in my humble opinion), saving
significant time can simplify, create happier employees and customers, and decrease
customer acquisition costs for example. Think rationally, and have candid conversations
about opportunity cost. Many investments in cloud technology and 3D printing can take
processes from months and weeks, to days and minutes.
4. Consider assessing the acceptability of independent investments. Consider
calculating the internal rate of return (IRR), of an investment when making a go/ no-go
decision. This simple computation equates investment present value cash inflows with
the present value of outflows. IRR is basically the minimum rate an investment must earn
to be acceptable, but be cognizant that what is planned is not always executed as planned.
Given the IRR is greater than the required rate of return (cost of capital) the investment
should prove to be acceptable. If the IRR is less that the rate of return, you will now have
some insights into investment improvement areas or mission critical components that
could make or break the investment. Have a standard minimum threshold in place that is
complimented with resource allocation.
5. Consider investment approach and analysis. Mutually exclusive investments are
better evaluated with NPV rather than IRR analysis. This is because mutually exclusive
investments involve competing projects which are better assessed utilizing NPV models
to correctly identify best option investment choices and alternatives. Some IRR
applications may actually point to inferior investments as they are based on single projects
and not a holistic consideration. Have a structured approach that works for your firm or
team leadership. Filter through the big data: extract the right data, conduct the right
analysis, and look at what is necessary to make the right decision. Experience will
enhance gut instincts. Dont forget, it is just as important understand your strategy, the
economics, and human behaviors that can impact your business, as it is to understand how
to read a balance sheet or statement of cash flows.
6. Consider taking the time for taxes. All cash flows in a capital investment decision
should be after tax cash flows, furthermore dependable and accurate tax data is vital
when it comes to capital and investment budgeting. If your team isnt converting your
gross cash flows to after-tax cash flows right now, they should be. Company leadership
and management should hold each other accountable for the projections and cash flow
accuracy. The two main ways to compute after-tax cash flows are the decomposition
method, and the income statement method. Use the method that best works for your
business, as each one differs in cash flow implications and laws vary by location.
7. Consider standard process and post implementation audits. Dont expect, what
you dont inspect. Have a plan and procedure in place to compare the actual investment
performance to the expected performance. Spend the proper time, before investing a dime,
and make sure your team has clearly defined the outcome for investment success.
Auditing should be looked at in a positive light. You want to confirm your investment
decision has, or is paying itself off as planned; however, if the investment is coming up
short you have now created a learning opportunity, and can identify corrective courses of
action to ideally bring your team through that threshold of defined success.
Source: Management Accounting, 7 Edition, by: Hanson, D. and Mowen M.
https://www.linkedin.com/pulse/20140618185925-17463039-seven-strong-
considerations-for-capital-investment-decisions

BUDGETS
Capital budgeting is a step by step process that businesses use to determine the merits of
an investment project. The decision of whether to accept or deny an investment project
as part of a company's growth initiatives, involves determining the investment rate of
return that such a project will generate. However, what rate of return is deemed acceptable
or unacceptable is influenced by other factors that are specific to the company as well as
the project. For example, a social or charitable project is often not approved based on rate
of return, but more on the desire of a business to foster goodwill and contribute back to
its community.

Capital budgeting is important because it creates accountability and measurability. Any

business that seeks to invest its resources in a project, without understanding the risks and
returns involved, would be held as irresponsible by its owners or shareholders.
Furthermore, if a business has no way of measuring the effectiveness of its investment
decisions, chances are that the business will have little chance of surviving in the
competitive marketplace.

Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is
a measurable way for businesses to determine the long-term economic and financial
profitability of any investment project.

Capital budgeting is also vital to a business because it creates a structured step by step
process that enables a company to:
1. Develop and formulate long-term strategic goals the ability to set long-term
goals is essential to the growth and prosperity of any business. The ability to
appraise/value investment projects via capital budgeting creates a framework for
businesses to plan out future long-term direction.
 2. Seek out new investment projects knowing how to evaluate investment
projects gives a business the model to seek and evaluate new projects, an
important function for all businesses as they seek to compete and profit in their
industry.
3. Estimate and forecast future cash flows future cash flows are what create
value for businesses overtime. Capital budgeting enables executives to take a
potential project and estimate its future cash flows, which then helps determine if
such a project should be accepted.
4. Facilitate the transfer of information from the time that a project starts off as
an idea to the time it is accepted or rejected, numerous decisions have to be made
at various levels of authority. The capital budgeting process facilitates the transfer
of information to the appropriate decision makers within a company.
5. Monitoring and Control of Expenditures by definition a budget carefully
identifies the necessary expenditures and R&D required for an investment project.
Since a good project can turn bad if expenditures aren't carefully controlled or
monitored, this step is a crucial benefit of the capital budgeting process.
6. Creation of Decision when a capital budgeting process is in place, a company
is then able to create a set of decision rules that can categorize which projects are
acceptable and which projects are unacceptable. The result is a more efficiently
run business that is better equipped to quickly ascertain whether or not to proceed
further with a project or shut it down early in the process, thereby saving a
company both time and money.
Unlike other business decisions that involve a singular aspect of a business, a capital
budgeting decision involves two important decisions at once: a financial decision and an
investment decision. By taking on a project, the business has agreed to make a financial
commitment to a project, and that involves its own set of risks. Projects can run into
delays, cost overruns and regulatory restrictions that can all delay or increase the
projected cost of the project.

In addition to a financial decision, a company is also making an investment in its future

direction and growth that will likely have an influence on future projects that the company
considers and evaluates. So to make a capital investment decision only from the
perspective of either a financial or investment decisions can pose serious limitations on
the success of the project.

Read more: Capital Budgeting: The Importance Of Capital

Budgeting http://www.investopedia.com/university/capital-
budgeting/importance.asp#ixzz4imjERST1

NET FLOWS OF INFLATION

Net present value (NPV) is a technique that involves estimating future net cash flows of
an investment, discounting those cash flows using a discount rate reflecting the risk level
of the project and then subtracting the net initial outlay from the present value of the net
cash flows. It helps in identifying whether a project adds value or not.
Inflation is a phenomenon that results in decrease in purchasing power and results in
increases in revenue and costs. It affects estimates of future cash flows. In order to make
better decision, accurate capital budgeting calculations are important, which are possible
only when all the financial variables are taken care of.
Methods
There are two ways in inflation can be accounted for while calculating net present value:
1. Nominal method: converting real cash flows to nominal cash flows and
discounting them using nominal discount rate
2. Real method: estimating real cash flows and discounting them using real
discount rate
The final net present value is same under both methods.
Under the nominal method, net cash flows in time t are calculated by the following
formula:
Nominal Cash Flows at Time t = Real Cash Flows at Time t (1 + Inflation Rate)t
Under the real method, real cash flows and real discount rate are used.
Relationship between nominal discount rate, real discount rate and inflation is given
below:
Nominal Discount Rate
= (1 + Real Discount Rate)(1 + Inflation Rate) 1
Real Discount Rate + Inflation Rate
Example 1: Inflation adjustment using nominal cash flows
M2 SWF is considering a project that is expected to generate $10 million at the end of
each year for 5 years. The initial outlay required is $25 million. A nominal discount rate
of 9.2% is appropriate for the risk level. Inflation is 5%.
You are the companys financial analyst. The companys CFO has asked you to calculate
NPV using a schedule of future nominal cash flows.
Solution
Nominal cash flows are calculated for each year as follows:
Year 1 = $10 million (1+5%)1 = $10.5 million
Year 2 = $10 million (1+5%)2 = $11.3 million
Year 3 = $10 million (1+5%)3 = $11.58 million
Year 4 = $10 million (1+5%)4 = $12.16 million
5
Year 5 = $10 million (1+5%) = $12.76 million
These nominal cash flows are to be discounted using nominal discount rate, which is 9.2%
Home > Managerial Accounting > Capital Budgeting > NPV and Inflation

NPV and Inflation

Net present value (NPV) is a technique that involves estimating future net cash flows of
an investment, discounting those cash flows using a discount rate reflecting the risk level
of the project and then subtracting the net initial outlay from the present value of the net
cash flows. It helps in identifying whether a project adds value or not.
Inflation is a phenomenon that results in decrease in purchasing power and results in
increases in revenue and costs. It affects estimates of future cash flows. In order to make
better decision, accurate capital budgeting calculations are important, which are possible
only when all the financial variables are taken care of.
Methods
There are two ways in inflation can be accounted for while calculating net present value:
1. Nominal method: converting real cash flows to nominal cash flows and
discounting them using nominal discount rate
2. Real method: estimating real cash flows and discounting them using real
discount rate
The final net present value is same under both methods.
Under the nominal method, net cash flows in time t are calculated by the following
formula:
Nominal Cash Flows at Time t = Real Cash Flows at Time t (1 + Inflation Rate)t
Under the real method, real cash flows and real discount rate are used.
Relationship between nominal discount rate, real discount rate and inflation is given
below:
Nominal Discount Rate
= (1 + Real Discount Rate)(1 + Inflation Rate) 1
Real Discount Rate + Inflation Rate
Examples
Example 1: Inflation adjustment using nominal cash flows
M2 SWF is considering a project that is expected to generate $10 million at the end of
each year for 5 years. The initial outlay required is $25 million. A nominal discount rate
of 9.2% is appropriate for the risk level. Inflation is 5%.
You are the companys financial analyst. The companys CFO has asked you to calculate
NPV using a schedule of future nominal cash flows.
Solution
Nominal cash flows are calculated for each year as follows:
Year 1 = $10 million (1+5%)1 = $10.5 million
Year 2 = $10 million (1+5%)2 = $11.3 million
Year 3 = $10 million (1+5%)3 = $11.58 million
Year 4 = $10 million (1+5%)4 = $12.16 million
5
Year 5 = $10 million (1+5%) = $12.76 million
These nominal cash flows are to be discounted using nominal discount rate, which is 9.2%
All amounts are USD in million.
Year 1 2 3 4 5 Total
Nominal cash flows 10.50 11.03 11.58 12.16 12.76
PV discount rate @ 9.2% 0.916 0.839 0.768 0.703 0.644
nominal
PV of cash flows 9.62 9.25 8.89 8.55 8.22 44.52
Net present value = $44.52 $25 million = $19.52 million