Sample Essay On Capital Budgeting

Abstract

Capital budgeting is the basis for planning and forecasting activities of any organization. Capital budgeting is the process of selecting and implementing nai-more efficient capital projects from the perspective of maximizing the rate of return and minimize the cost of their funding sources. Thus understand the need and importance of capital budgeting, both for business and for the economy as a whole. Planning - this attribute is not a single economic entity, not the requirements of today's business environment, it is a natural strategic and tactical business development.
The activities of businesses are so diverse that the goals and objectives of their establishment and operation cannot be described unambiguously. In modern society, business organizations engaged in a wide variety of types of operations. They are not only part of the financial system of the country but they themselves organize cash flow and credit relations; they are being financed through various activities. Capital budgeting as one of the most effective planning tools allows you to extend the time horizon and predict the development of the company in the coming period.
Noting the positive trends in capital budgeting, the attention is being focuses on existing risks at the level of individual commercial organizations and across the country.

Body

Capital budgeting is the process of selecting and implementing the most effective capital projects from the perspective of maximizing the rate of return and minimize the cost of their funding sources.
Economic nature of the capital budget relates to investment planning and budgeting. However, if we consider the budgeting of capital investments from the position of choosing the best method of financing, the investment budget can be interpreted as financial, closely related to the budget cash flow and balance sheet.
For various investment companies have unequal value, which is determined by the scale of production and business activities, industry characteristics, the pace of development and other factors.

In the budgeting process solves the following main tasks:

compliance with the investment proposal with the strategic objectives of the company;
the time factor and the cost of capital when considering the project;
the risk and profitability of real investments;
need to analyze the investment costs and benefits (profits) for each project;
knowledge of maximum profitability (effectiveness) of investment proposals;
monitoring the execution of project and compare the results with the primary expectations (in the process of monitoring of the project);
impact of the project on the company's financial condition;
calculation of cash flow for the entire lifetime of the project.
These tasks it is advisable to take into account in the design and execution of the investment budget. Strategic decisions on investments can significantly affect the development of the enterprise.
The key issues addressed in the analysis of investment: to implement a new project or to replace existing items of capital?

The main types of decisions made on investments include:

program to reduce production costs;
replacement of physical assets;
the creation of new production facilities or the expansion of existing ones;
implementation of advertising campaigns;
investing in non-commercial purposes (environmental, social events, etc..);
program of introducing new technology (innovation).
Since investment decisions are made under conditions of uncertainty, it is advisable to assess the risk associated with the investment, and to consider the development of the project in time. The key task of the project proponent is to minimize the probability of incorrect management decisions.
Many businesses often do not deal with individual projects, and with an investment portfolio consisting of several projects. Selection and implementation of projects of this portfolio is carried out in the framework of the investment budget (capital budget).
Reasonable financing plan determines the effectiveness of a specific project. In practice, this financial plan called "budget implementation of the investment project." Budget reflects the operational plan short-term (up to one year). In this plan include the costs and receipt of funds related to the implementation of the project.

Background information for the preparation of this budget are:

1) operational (calendar) project implementation plan;
2) the overall strategy and tactics of investment project financing at the expense of their own, borrowed and borrowed sources;
3) estimates for the execution of certain types of construction and installation works, developed for the project as a whole;
4) a tentative schedule of cash flow, based on a feasibility study and business plan for the project;
5) the financial position of the initiator of the project in the current period and the forecast for the future.
With the above information, you can make informed investment budget for the enterprise as a whole. For its development are often attracted to the information provided in the operating and financial budgets. Therefore, the investment budget is working closely with other operational plans of the enterprise.
The purpose of planning capital investments is to ensure implementation of the project provided for building regulations volumes and technologies. As the volume and structure of capital costs in the pre-feasibility study substantiate, the estimates of these costs in the budget for the coming year (quarter) is reduced to the following procedures:
1) allocation of the total investment that their shares, which refers to the current period under consideration;
2) specification of the scope of capital expenditures of the current period based on the requirements of the contractor to change the technology of construction and installation works;
3) adjusting the volume and structure of investments due to changes in prices in the current period for construction materials, equipment, transportation, and so on. Etc .;
4) specification of the initial amount of capital expenditures, taking into account the financial reserve envisaged in the contract with the contractor for reimbursement of incidental expenses.
The flow of funds in the development of the investment budget includes a cash inflow of resources in the context of separate sources: own, borrowed and borrowed. The process of developing the income section of the budget includes the following procedures:1) Clarification of the scope of the receipt of funds, which should correspond to the total capital investment;
2) Clarification of income sources in their structure (internal and external);
3) Ensure that the time flow of investment resources flows of capital expenditures.
The timing of planning investment budget is divided into annual (with quarterly ~ break indicators) and quarterly (with monthly income distribution and capital costs).

In the process of capital budgeting for specific projects are the following steps:

approval of the technical and economic assessments of the project;
approval of the project;
distribution of responsibility and authority to implement it;
subsequent support of the project.
Proposal for investment should include a description of the future project: the date of the start / end of the project; its organizational and information support; sources of financing; performance parameters of the project and so on. If the project exceeds the established limits in terms of investment, it requires special approval from senior management of the enterprise. A project that does not meet the expected performance or under the influence of current circumstances is no longer necessary may be suspended.

In the process of capital budgeting it is necessary to find answers to the following questions.

Is the investment offer long-term goals of the company?
Are external factors taken into account in the preparation of the capital budget: political, economic, production, marketing and other conditions?
Does the project to strengthen the financial stability and solvency of the enterprise?
What is the quality of financial and economic parameters of the project?
In what order to identify possible cash flow from the project?
As included in the draft investment risks?
Whether taken into account the ratio of risk / return?
Has into account the time value of money and in considering the proposal?
Examining whether the implementation of the project on a periodic basis and compared the results with the primary expectations?
Answers of many of these questions can be found in the feasibility study and business plan of the project.
Capital budget of the project consists of two parts:
capital expenditure by type;
sources of financing investment.
Capital investments are often divided into normal and special. Normal investments are accompanied by low capital cost and are designed to maintain the daily operational activities of the enterprise. As a rule, they do not cause significant cash outflows, such as a slight to replace the retiring equipment. Special investments intended for bulk purchase of new equipment for the production of a single product (pilot production) and others. They are usually costly. Most of the investment projects on offer and plan a production manager. Projects must be approved by senior management.
Investments are grouped and are budgeted for the category, the need for them, expected results and satisfaction. In the case of small investment managers and enterprise branch offices may be entitled to their approval.

In practice, two basic approaches to the development of the capital budget are used:

1) The first one is based on the criteria of internal rate of return (IRR);
2) The second is based on the effect of the above criteria pure (NPV).

The content of the first approach, the following:

all available projects are ranked by descending IRR;
continue to carry out their selection for serial implementation, following a mandatory rule: IRR> CC (cost of capital).
The second approach to capital budgeting is based on the concept of net present effect (NPV). In the absence of any restrictions calculation procedure is as follows:
1) set the value of the discount rate - the total for all projects, either individually for each project;
2) determine the net present value of the effect of the following projects: all independent projects (if any source of coverage) with NPV> 0 include the investment budget;
3) alternative projects selected project with a maximum value of NPV.
If there are timing constraints or resource constraints, the method of calculation is complicated because there is a problem of optimization of the capital budget.
This problem is often solved by adjusting the combination of projects that maximizes NPV. Then pick a combination of projects taking into account the divisibility (possible partial implementation) or indivisibility (the full enjoyment).
The second reason is due to a significant decrease in the effectiveness of projects in their implementation. In such a situation often have to make a decision on "exit" from the individual projects and the adjustment of the capital budget.
High responsibility of decision-making about the "output" of the projects related to the fact that they often lead to loss of anticipated profits (income) and even parts of the capital invested. Such management decisions should be based on in-depth analysis of the current investment market conditions and forecast its future development.

The most important way out of unsustainable projects:

termination of the financial operations of the project prior to construction and installation works;
selling partially implemented project in the form of unfinished construction of the facility;
sale of the construction of facilities at the stage of the operation or of certain types of real assets, and so on.
A key criterion for the decision to "exit" from the inefficient project is the expected value of the internal rate of return (IRR).
Analysis of the performance of the capital budget is carried out after examination and evaluation of the operational and financial budgets. This is due to the fact that variations in financial budgets (budgeted cash flow and balance sheet) is defined as the current economic activities and investments in fixed assets. Recent carried out both by internal and external financial sources. During the analysis it is advisable to compare planned and actual investment balances.
Efficiency of investment plans in the long-term budget for one to three years. Within the short-term budget (for the quarter) approach to the analysis of investments is controlled by the development of investment, ie. E. Expenditure of funds for investment. This leads to immobilization of current assets and lower liquidity in the balance sheet.

At the same time the capital budget within the short term effect on income and expenses due to:

1) deinvestitsy - possible sale of assets under: construction and fixed assets;
2) depreciation as part of production costs;
3) increasing the amount of net profit due to the commissioning of new production facilities or upgrading existing facilities.
It should be emphasized that the analysis of the execution of the capital budget is fixed and opportunity costs for lost profits from the failure of the planned commissioning of the facilities during the year.
Thus, the execution of the capital budget affects both the current financial condition of the company, and the final financial result.
The cumulative effect of the execution of the capital budget (as largest disbursement, and value of commissioned projects) is expressed by the following parameters:
1) increase in net income;
2) increase of capital assets (fixed assets);
3) a decrease in the volume of construction in progress due to the commissioning of new facilities and uninstalled equipment;
4) changes in the value of long-term liabilities in the balance sheet liabilities due to repayment of loans;
5) change in the volume of monetary assets (increase or decrease in the cash balance on the current account).
Consequently, analysis of the execution of the investment budget is of interest to the company’s management from the perspective of ensuring financial stability and achieves the desired financial results.

References

Varshney, R.L.; K.L. Maheshwari (2010). Manegerial Economics. 23 Daryaganj, New Delhi 110002: Sultan Chand & Sons. p. 881. ISBN 978-81-8054-784-3.
Sullivan, arthur; Steven M. Sheffrin (2005). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 375. ISBN 0-13-063085-3.
Investment Decisions and Capital Budgeting, Prof. Campbell R. Harvey; The Investment Decision of the Corporation, Prof. Don M. Chance
International Good Practice: Guidance on Project Appraisal Using Discounted Cash Flow, International Federation of Accountants, June 2008, ISBN 978-1-934779-39-2
Long-Term Financial Statements Forecasting: Reinvesting Retained Earnings, Sergei Cheremushkin, 2008