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Importance of forecasts and budgeting capital rationing

Nature of Capital Budgeting 1. What is capital budgeting and why is it important? The overall objective of capital budgeting is to provide management with financial input so that better decisions can be made. In today's business climate, firms either move ahead or fall behind their competitors—there's no "staying even.

Capital budgeting is critical to this task and to making good investment choices and avoiding bad ones. This sounds like a straightforward exercise and in some instances it is. If a storm tears the roof off the firm's warehouse, replacing it would not seem to require all the formality implied by the above definition.

So it is probably best to relegate the capital budgeting exercise to major and discretionary investment expenditures that are less than routine in nature. Thus we take a formal view of the capital budgeting process although it can be informal as well.

A more formal view of the process will usually relegate the investment task to a special capital budgeting team. Scarcity and allocation - Scarcity and allocation provide the backdrop for the need to budget financial capital.

  • The two cash flows are simply added to produce a final cash flow;
  • This inflow must be related to the overall replacement decision, so it's counted here as part of the initial investment;
  • In this case there would be a recoupent of net working capital a cash inflow as accounts receivable would be collected and not continued and as accounts payable ceased to exist;
  • Budgeting vs rationing capital budgeting is not the same thing as capital rationing.

Financial capital is scarce and limited to the firm. Like any scarce resource these funds have a price called the cost of capital and must be properly allocated or budgeted by the firm. Capital budgeting provides allocation guidance to management so that projects are selected that provide expected returns in excess of their cost.

Other reasons accurate capital budgeting is important include the following: Capital budgeting is concerned with investments that require a large up-front commitment of funds. Investment funds are typically committed for long periods of time.

Investment projects may not start generating operating cash flows for some time after the initial investment expenditure is made. It is usually difficult and costly to reverse a "bad" capital budgeting decision. To do so can sometimes lead to bankruptcy. Achievement of the firms long-run strategic goals is highly dependent upon a continuing stream of good projects.

Capital budgeting should not be thought of as a one-time task. Motives for capital budgeting expenditures: There are primarily three motives for making major capital expenditures: This motive involves increasing the productive capacity of the firm, usually through the building or acquisition of major fixed assets. The expansion motive is usually geared towards increasing market share via additional sales capacity. This involves replacing existing assets with new or more advanced assets which provide the same function.

Nature of Capital Budgeting

Replacement is usually associated with an anticipated reduction in the cost of production rather than sales enhancement. This includes rebuilding or overhauling existing assets to improve efficiency.

Numbers 2 and 3 can easily be considered part of the replacement process. Other reasons for making capital expenditures might be for intangibles that are expected to improve profitability.

Capital Rationing and the Capital Budgeting Decision Financial Management

Some examples would be re-educating the workforce, undertaking an advertising campaign, or possibly carrying out government-mandated defensive investment aimed at internalizing negative social costs e. A generic description of capital budgeting as a "process": Capital budgeting is a process in that it follows certain steps that occur over importance of forecasts and budgeting capital rationing.

Consider this rough outline for an expansion situation. Proposal generation is a search for a new idea that offers stockholders more than it will cost to implement the idea. Such areas as research and development, marketing, finance, and accounting analysis, perhaps some engineering input, and a feasibility study would all be involved. Proposal generation can best be thought of as a search for a monopoly product or service.

Once a monopoly idea has been identified, it must be sustainable. A new and promising capital budgeting project can only lead to an expected long-term abnormal profit for the firm if others cannot quickly exploit the idea. This may be the case with proprietary ideas inventions that, because of their unique nature or because of legal restrictions i. You can see how the quest for a sustainable monopoly position is intimately connected with a firms research and development program.

The process of capital budgeting is a forecasting exercise. It is ex ante in nature—it occurs before-the-fact. Once an idea has been quantified in terms of feasibility and cost, the next step in the process is to carry sales and cost forecasting over some reasonable time horizon. The emphasis here is on accurate forecasts of the pro-forma incremental net cash flows associated with the project. Obviously accurate sales and cost forecasts are critical to making good capital budgeting decisions.

Application of the various capital budgeting techniques: In order to make appropriate "accept" or "reject" decisions, the forecasted incremental cash flows must be subjected to the mathematical decision criteria associated with the various capital budgeting methods.

We will describe this part of the process in the next lesson. The process does not end with the crunching of numbers. Rather, the project must be implemented so that actual and projected outcomes can be compared. If there are large negative deviations between actual and forecasted net cash flows, corrective action should be taken.

Should corrective measures fail, termination is the final step of the process.

Budgeting, Forecasting and the Planning Process

Accurate cost and sales forecasts and net incremental cash flow forecasts will minimize a termination outcome. Other important capital budgeting terminology: Capital budgeting comes with its own set of terms and sub-concepts. Let's deal with these here so that we can go directly to the techniques in the next lesson. Cash flows, not accounting income: Unlike financial statement analysis, capital budgeting deals exclusively with forecasted cash flows, not accrual measures of net income.

  • This includes rebuilding or overhauling existing assets to improve efficiency;
  • The lost rental income that the firm will not be receiving if it asks the current tenant to leave is also an opportunity cost;
  • Relevant worked examples will illustrate the learning points and tools and techniques in a real-world environment.

However, a rough measure of a project's cash flow can be obtained from the accrual-based income statement. An example will be given later in this Lesson Plan. Project investments are typically not carried out in a random fashion. Rather the firm will usually follow a planning cycle in which a pre-selected number of projects will be undertaken over a given number of years.

Independent versus mutually exclusive projects: A distinction between the following two project types is necessary in order to correctly interpret the capital budgeting directives that will be discussed in Lesson Plan 4B. Independent projects have cash flows that are independent of each other. Since independent projects perform different functions the firm can undertake as many as it wishes, assuming the firm has the funds and assuming each project meets the requirement that it offers an expected rate of return that exceeds its cost.

The seven projects along with their status and expected annual rates of return are listed in the table below.

Importance of forecasts and budgeting capital rationing

Rank the projects based upon their expected rates of return. A ranking of the projects is G, B, E, and A. The others are rejected. All independent projects can be chosen since they do not compete with each other. Capital rationing or unlimited funds: Firms under a capital rationing constraint have a management-determined limit on capital expenditures for a given planning period.

This constraint means some otherwise acceptable projects will not be undertaken. The procedures for dealing with a capital rationing situation lead to a situation where the rate of return on the dollars spent in the aggregate is maximized as opposed to judging projects individually. We will not deal with this situation here. An unlimited funds situation will be one where all acceptable projects can be funded with the firms financial capital resources. The accept or reject approach is just that: A determination is made as to whether or not a project meets some minimum acceptance criteria.

If so, it is accepted; if not, it is rejected. A ranking approach lists projects' rates of return from highest to lowest. A determination is then made as to which projects make the "cut. Conventional or non-conventional cash flow patterns? A project's forecasted timeline of cash flows can be classified as conventional or non-conventional. A non-conventional pattern means that besides the negative initial investment cash flow, one or more of the operating cash flows is negative. We will not deal with this latter situation here.

  • Capital budgeting is concerned with investments that require a large up-front commitment of funds;
  • The projected levels of net operating cash flows for both presses for the next four years from today are listed below;
  • Sunk costs versus opportunity costs;
  • Project investments are typically not carried out in a random fashion;
  • The following equations can help understand the computation of a capital gain or capital loss on the sale of a used piece of machinery.

A timeline example of a conventional cash flow pattern is given below. An incremental per period cash flow is the additional cash flow that is expected to be generated by a proposed new project. Capital budgeting methods should only be applied to the expected incremental cash flows, not the expected levels of cash flows. The idea of incremental cash flows is particularly applicable to a replacement decision.

The XYZ Company is considering replacing a current drill press with a new computer-operated model. Both projects have an expected life of four years. The projected levels of net operating cash flows for both presses for the next four years from today are listed below. List the incremental operating cash flows if the replacement is made.

Capital budgeting methods should only be applied to the incremental dollar amounts listed in column 4. Thus to use the proposed replacement cash flow levels would amount to double-counting for cash flows to be received if nothing is done. This could lead to an incorrect decision.