Chapter 1

Capital Budgeting Techniques

10-1
Learning Goals

LG1 Understand the key elements of the capital budgeting

process.

LG2 Calculate and evaluate the payback period.

LG3 Calculate and evaluate the net present value (NPV)

and economic value added (EVA)

10-2
Learning Goals

LG4 Calculate and evaluate the internal rate of return

(IRR).

LG5 Use net present value profiles to compare NPV and

IRR techniques.

LG6 Discuss NPV and IRR in terms of conflicting

rankings and the theoretical and practical strengths of
each approach.

10-3
Overview of Capital Budgeting

• Capital budgeting is the process of evaluating and

selecting long-term investments that are consistent with
the firm‟s goal of maximizing owner wealth.
• A capital expenditure is an outlay of funds by the firm
that is expected to produce benefits over a period of time
greater than 1 year.
• An operating expenditure is an outlay of funds by the
firm resulting in benefits received within 1 year.

10-4
Overview of Capital Budgeting:

The capital budgeting process consists of five steps:

1. Proposal generation. Proposals for new investment projects are made at all
levels within a business organization and are reviewed by finance
personnel.
2. Review and analysis. Financial managers perform formal review and
analysis to assess the advantage of investment proposals
3. Decision making. Firms typically delegate capital expenditure decision
making on the basis of dollar limits.
4. Implementation. Following approval, expenditures are made and projects
implemented.
5. Follow-up. Results are monitored and actual costs and benefits are
compared with those that were expected.

10-5
Overview of Capital Budgeting:
Basic Terminology
Accept-Reject versus Ranking Approaches
– An accept–reject approach is the evaluation of capital
expenditure proposals to determine whether they meet the firm‟s
minimum acceptance criterion.
– A ranking approach is the ranking of capital expenditure
projects on the basis of some predetermined measure, such as
the rate of return.

10-6
 The Purpose of Budgeting

• Budget

– An estimate of the income and expenditures

during a given period of time based on the
mission, goals, and objectives of an organization.

– In other words, an organization‟s business plan

expressed in financial terms.

10-7
The Purpose of Budgeting

• Budget helps to set the parameters for

activities to be done during the budget period

• Acts as a control device for regulating

spending in the organization

• Provides an objective set of criteria against

which a manager‟s performance can be
measured
10-8
 Benefits of Budgeting

• Requires all levels of management to plan ahead

• Provides definite objectives for evaluating performance at each level
of responsibility
• Creates an early warning system for potential problems
• Facilitates coordination of activities within the organization
• Results in greater management awareness of the entity’s overall
operation
• Motivates personnel throughout the organization to meet planned
objectives

10-9
What is Financial Forecasting?

 It is a Part of Planning process.

 They are inferences as to what the future may be.
 Extends over a time horizon.
 Based on:
i. Economic assumptions (interest rate, inflation rate, growth rate and
so on).
ii. Sales forecast.
iii.Pro forma statements of Income account and Balance sheet.
iv.Asset requirements.
v. Financing plan.
vi.Cash Budget
10-10
 The Need

 Financial Manager prepares Pro forma or projected

financial statements to:
a. Assess the firm‟s forecasted performance is in line
with Targets and expectations of investors.

b. Examine the effect of proposed operating changes.

c. Estimate the financing needs of the firm.

d. Estimate the future free cash flows (FCF).

10-11
ZERO BASE BUDGETING

10-12
INTRODUCTION

• Zero base budgeting (ZBB)is an alternative to incremental

budgeting . ZBB was introduce at Texas in USA in 1969 by Peter
Phyrr , who is known as the father of ZBB . This is not based on
incremental approach and previous year’s figures are not taken as
the base for preparing next year’s budget. Instead the budget
figures are developed with zero as the base , which means that a
budget will be prepared as if it is being prepared for a new
company for the fist time.

10-13
 Zero Base Budgeting
Purpose of Zero-Base Budgeting
The Objective of Zero Based Budgeting is to “reset
the clock” each year. The Traditional incremental
budgeting assumes that there is a guaranteed
budgetary base-the previous year’s level of
appropriations -and the only question is how much of
an increment will be given. Zero Based Budgeting
implies that managers need to build a budget from the
ground up, building a case for their spending as if no
baseline existed- to start at zero.

10-14
The purpose of ZBB is to revaluate and
reexamine all programs and expenditures for
each budgeting cycle by analyzing workload
and alternative levels of funding for each
program or expenditure. Through this system,
each program is justified .

10-15
 Application of ZBB

The practical application of ZBB involves the use of the

“Decision Package”. All budgetary procedures involve
an identification of organizational objectives. In the
context of these objectives, ZBB involves three stages:

1. Identification of decision units.

2. Development of decision package.
3. Review and ranking of decision packages.

10-16
 Main features of ZBB

• All budget items both old and newly proposed are

considered totally afresh.
• Amount to be spent on each budget item is to be
totally justified.
• Department objectives are linked to corporate goal.
• The main stress in not on „how much‟ a department
will spend but on „why‟ it need to spend.
• Manager at all levels participate in ZBB process and
they have corresponding accountabilities.

10-17
 ADVANTAGES

• In ZBB all activities included in the budget

are justified on cost benefit considerations
witch promote more effective allocation of
resources.

• Cost behavior patterns are more closely

examined.

10-18
• It adds psychological push to employees
to avoid wasteful expenditure.

• It is an education process and can

promote a management team of talented
and skillful people who tend to promptly
respond to changes in the business
environment.

10-19
 DISADVANTAGES

• ZBB leads to an enormous increase in paper

work and results in high cost of preparing budget
every year.

• Managers may resist new ideas and changes.

They may feel threatened by ZBB because all
expenditures are questioned and need to be
justified.

• In ZBB there is danger of emphasising short-

term gains at the expense of long-term benefits.
10-20
• It may not always be easy to properly rank
decision packages and this may give rise
to conflicts.

• For introducing ZBB , managers need to

be given proper training and education
regarding this new concept, its pros and
con and implementation.

10-21
Flow of Information to Top of
Organization

10-22
 Master Budget

• A set of interrelated budgets that

constitutes a plan of action for a specific

time period

10-23
 Operating Budgets

• Individual budgets that result in a

budgeted income statement

10-24
 Financial Budgets

• Individual budgets that indicate the cash

resources needed for expected operations

and planned capital expenditures

10-25
Components of Master Budget

10-26
 Sales Forecast

• The projection of potential sales for the

industry and the company‟s expected share

of such sales

10-27
 Sales Budget

• An estimate of expected sales for the

budgeted period

• It represents managements best estimate

of sales revenue for the budget period

• Each of the other budgets depends on the

sales budget
28
 Production Budget

• A projection of units that must be produced to

meet expected sales, including ending
inventory

Production requirements formula

• The production budget, in turn, provides the
basis for determining the budgeted costs for
each manufacturing cost element.
29
 Direct Materials Budget

• An estimate of the quantity and costs of direct materials

to be purchased, including a realistic ending inventory

Formula for direct materials quantities

• unsuitable inventories could result in temporary
shutdowns of production

10-30
 Direct Labour Budget

• A projection of the quantity and cost of direct labour to be

incurred to meet production requirements

• The direct labour budget is critical in maintaining a labour force

that can meet expected levels of production

10-31
 Manufacturing Overhead Budget

• Shows expected manufacturing overhead costs for the budget period

• Differentiate between the fixed and variable overhead costs

• The fixed overhead costs are assumed and “Hayes Company” expects the
following variable costs per direct labour hour:

– Indirect materials $1.00

– Indirect labour $1.40
– Utilities $0.40
– Maintenance $0.20

10-32
 Selling and Administrative Expenses Budget

• Is a projection of anticipated operating expenses

• Differentiation between fixed and variable costs

• Fixed cost amounts are assumed, and” Hayes” expects the

following variable costs per unit sold (from sales budget):

– Sales commission $3.00

– Freight out $1.00

10-33
 Budgeted Income Statement

• An estimate of the expected profitability of operations

for the budget period

• Once established, the budgeted income statement

provides the basis for evaluating company

performance

10-34
 Financial Budgets

• Consists of:

– Capital Expenditure Budget

– Cash Budget

– Budget Balance Sheet

10-35
 Cash Budget
• A projection of anticipated cash flows
• It has three sections
– Cash receipts
– Cash disbursements
– Financing
as well as beginning and ending cash balances
• Must be prepared in sequence – ending for one is beginning for
next
• Although for one year usually prepared on a monthly basis

10-36
 Cash Receipts

• Includes:
– Receipts from company‟s principal source(s) of
revenue such as cash sales and collections from
customers on credit sales

– Receipts of interest and dividends

– Receipts from planned sales of investments, plant

assets and the company‟s shares (stock)

10-37
 Cash Disbursements

• Shows expected payments for direct materials, direct

labour, manufacturing overhead and selling and
administrative expenses

• Also includes projected payments for in taxes,

dividends, investments, and plant assets

10-38
 Financing

• Shows expected borrowings and the

repayments of the borrowed funds plus

interest

10-39
 Budgeted Balance Sheet

• A projection of the financial position at the

end of the budget period

• This budget is developed from the

budgeted balance for the preceding year
and the budgets for the current year

10-40
 Merchandise Purchases Budget

• The estimated cost of goods sold to be

purchased by a merchandiser to meet
expected sales
• Uses a merchandise purchases budget
instead of a production budget
• Does not use the manufacturing budgets
(direct materials, direct labour, and
manufacturing overhead)
10-41
 Merchandise purchases formula

• Non-manufacturing companies such as

service enterprises and not-for-profit
organizations also need budgeting!
10-42
 Monitoring Budget and

Responsibility Accounting

Comparing actual performance with the budget –

Variance Analysis

10-43
 Budgetary Control

• One of the three main functions of

management is to control

• Budgets are useful in controlling operations

10-44
 Budgetary Control

• The use of budgets to control operations

• Compare actual results with planned

objectives

10-45
Budgetary Control

10-46