Integrating Budgets And Capital Investment Appraisal

Need for Budgeting

Discuss about the Integrating Budgets and Capital Investment Appraisal?

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 company’s revenues and expenses will be managed.

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.

It’s 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

Process of Budgeting

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 30^th 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 30^th 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 1^st 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 30^th 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 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).

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 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 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. (2001), Integrating Financial Management and Performance Management, OECD Journal on Budgeting

Finweb, (2012), The Importance of Budgeting, accessed online on 14^th February, 2016, available at https://www.finweb.com/financial-planning/the-importance-of-budgeting.html#axzz40Dd6Q0ut

Rothberg, A., (2013), The Importance of Business Budgeting, accessed online on 14^th February, 2016, available at, https://www.cfoedge.com/resources/articles/cfo-edge-the-importance-of-business-budgeting.pdf

Harbeler, C., Wahll, H., (2006), The Budget Process in a Hotel: A case study of Novotel, School of Business Economics and Law, Goteberg University

Hopwood, G., (1973), An Accounting System and Managerial Behaviour, Lexington, USA

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Wps.pearsoncustom, (NA), Capital Budgeting: Introduction and Techniques, accessed online on 14^th February, 2016, available at, https://wps.pearsoncustom.com/wps/media/objects/2426/2484590/FIN202_CH10.pdf

Drake, P., (NA), Capital Budgeting Techniques, accessed online on 14^th February, 2016, available at, https://educ.jmu.edu/~drakepp/principles/module6/capbudtech.pdf