Chapter 12

Budgeting
TABLE OF CONTENTS
• Summary
• Introduction to Budgeting and Budgeting Processes
• The Steps In Preparing The Budget
• Importance of Budgeting
• Introduction to Capital Budgeting
SUMMARY
SUMMARY
• Budgeting is a process whereby future income and expenditure are
decided in order to streamline the expenditure process. Budgeting is
done in order to keep track of the expenditures and income. It
serves as a monitoring and controlling method in order to manage
the finances of a business.
• Budgeting process is very crucial for any business entity. Without a
proper budget, a business can never keep track of how much it has
earned and how much it has spent. Budget serves a great guide by
which a business can oversee its income stream and can identify
potential dangers to it beforehand. Furthermore, budget acts as a
valuable tool in order to take control of how a business spends. A
budget makes sure that all the money is being spent in the right
direction and financial goals are attained.
SUMMARY
• Every company should have a well-thought-out budget that considers
the goals of the company, the motivation of employees and the financial
limitations of the company. Additionally, the company should consider
both the previous financial and business activities of the company as
well as the goals the company holds for the future
• The basic steps to follow when preparing a budget:
• Update budget assumptions.
• Review bottlenecks
• Available funding.
• Step costing points.
• Create budget package.
• Issue budget package.
• Obtain revenue forecast.
• Obtain department budgets.
• Review the budget.
• Process budget iterations.
• Issue the budget.
• Load the budget.
SUMMARY
• Creating a budget is not just an exercise that the CFO gives to the managers of
the company to provide busy work to those already very busy. A budget is a
comprehensive financial plan for achieving the financial and operational goals of
an organization. Used correctly, a budget is the map of the company’s strategic
plan. In creating the budget, the company is developing its objectives for the
acquisition and use of its resources. Once in place, it becomes a valuable
benchmark to determine how well the steps taken by management are ensuring
objectives are attained.
• Why Is Budgeting Important? There are many benefits derived from budgeting.
It formalizes the coordination of activities between departments while aligning
these activities to the big picture – the company’s strategic plan. It provides the
assignment of decision-making responsibilities and enhances management’s
responsibility. With a solid plan in place, all decision makers are working towards
the same goal. In addition, the budget improves performance evaluations –
providing a common base for discussion on how well the manager met his goals
and providing a talking point concerning why actual results veered from the
original budget. It encourages all areas within the business to become more
efficient, which rolls up to a greater efficiency company-wide.
SUMMARY
• Capital budgeting is the process in which a business determines and
evaluates potential large expenses or investments. These expenditures and
investments include projects such as building a new plant or investing in a
long-term venture. Often, a company assesses a prospective project's
lifetime cash inflows and outflows to determine whether the potential
returns generated meet a sufficient target benchmark, also known as
"investment appraisal.“
• Most business’ future goals include expanding their operations. This is
difficult to do if the company doesn’t have enough capital or fixed assets.
That is where capital budgeting comes into play.
• Capital budgets or capital expenditure budgets are a way for a company’s
management to plan fixed asset sales and purchases. Usually these budgets
help management analyze different long-term strategies that the company
can take to achieve its expansion goals. In other words, the management
can decide what assets it might need to sell or buy in order to expand the
company. To make this decision, management typically uses these three
main analyzes in the budgeting process: throughput analysis, cash flows
analysis, and payback analysis.
Section 1

INTRODUCTION TO BUDGETING AND BUDGETING PROCESSES

THE BUDGET—FOR PLANNING AND CONTROL

• Time and money are scarce resources

to all individuals and organizations;
the efficient and effective use of
these resources requires planning.
Planning alone, however, is
insufficient.
• Control is also necessary to ensure
that plans actually are carried out. A
budget is a tool that managers use to
plan and control the use of scarce A budget
resources. A budget is a plan showing Company’s
the company’s objectives and how objectives
management intends to acquire and A tool to
use resources to attain those plan and
control
objectives. scare
resources
THE BUDGET—FOR PLANNING AND CONTROL

• Companies, nonprofit organizations, • To judge the

and governmental units use many Responsibility performance of
different types of budgets. budget manager
• Responsibility budgets are designed
to judge the performance of an
individual segment or manager. • Long term capital
Capital project
• Capital budgets evaluate long-term budgets
capital projects such as the addition
of equipment or the relocation of a
plant.
• Plan future earnings in
• The planned operating budget helps Operating projected income
to plan future earnings and results in budget statement
a projected income statement.
• The financial budget helps
management plan the financing of • Management plan for
assets and results in a projected Financial assets and projected
budget balance sheet
balance sheet.
THE BUDGET—FOR PLANNING AND CONTROL

• The budgeting process involves

planning for future profitability
because earning a reasonable A budget :
return on resources used is a
primary company objective. A
company must devise some
Shows Formalizes
method to deal with the management’s management’s
uncertainty of the future. A operating plans for plans in quantitative
company that does no planning the coming periods terms
whatsoever chooses to deal with
the future by default and can
react to events only as they Anticipate results,
occur. Most businesses, however, Motivate individuals
and take action to
to strive to achieve
devise a blueprint for the actions remedy possible
stated goals
they will take given the poor results
foreseeable events that may
occur.
THE BUDGET—FOR PLANNING AND CONTROL

• Companies can use budget-to-actual

comparisons to evaluate individual
performance. For instance, the standard
variable cost of producing a personal
computer at IBM is a budget figure. This Better
Foster a
figure can be compared with the actual coordinate of
vision
activities
cost of producing personal computers to
help evaluate the performance of the
personal computer production
managers and employees who produce
personal computers. Benefits of
• Many other benefits result from the Reviews its
budget
preparation and use of budgets. For organization
Aware of
example: (1) businesses can better plan and
other
coordinate their activities; (2) managers managers’
changes if
become aware of other managers’ plans
necessary
plans; (3) employees become more cost
conscious and try to conserve More cost
resources; (4) the company reviews its conscious
organization plan and changes it when and try to
necessary; and (5) managers foster a conserve
vision that otherwise might not be resources
developed.
THE BUDGET—FOR PLANNING AND CONTROL

• The planning process that results in a formal Budget

budget provides an opportunity for various Provides an opportunity of
levels of management to think through and management to think for
commit future plans to writing. In addition, a
properly prepared budget allows management future plan.
to follow the management-by-exception
principle by devoting attention to results that
deviate significantly from planned levels. For
all these reasons, a budget must clearly reflect Management uses the
the expected results. management-by-exception
• In fact, the less stable the conditions, the principle, i.e. clearly reflects
more necessary and desirable is budgeting, expected results.
although the process becomes more difficult.
Obviously, stable operating conditions permit
greater reliance on past experience as a basis Budget stabilize operating
for budgeting. Remember, however, that conditions with greater
budgets involve more than a company’s past
results. Budgets also consider a company’s reliance.
future plans and express expected activities.
As a result, budgeted performance is more
useful than past performance as a basis for
judging actual results. Budget involves more than
company’s past results. Budget
consider future plans and
expected activities.
THE BUDGET—FOR PLANNING AND CONTROL

• A budget should describe management’s Budget as management’s

assumptions relating to: (1) the state of the assumptions
economy over the planning horizon; (2) plans
for adding, deleting, or changing product
lines; (3) the nature of the industry’s
competition; and (4) the effects of existing or
possible government regulations. If these
assumptions change during the budget
period, management should analyze the
effects of the changes and include this in an The effects of The state of the
evaluation of performance based on actual existing or economy over
results. possible the planning
government horizon
regulations
• Budgets are quantitative plans for the future.
However, they are based mainly on past
experience adjusted for future expectations. Plans for adding,
Thus, accounting data related to the past play The nature of the
deleting, or
an important part in budget preparation. The industry’s
changing product
accounting system and the budget are closely competition
lines
related. The details of the budget must agree
with the company’s ledger accounts. In turn,
the accounts must be designed to provide the
appropriate information for preparing the
budget, financial statements, and interim
financial reports to facilitate operational
control.
THE BUDGET—FOR PLANNING AND CONTROL

• Management should frequently

compare accounting data with
budgeted projections during the budget
• Cover a
Cash
period and investigate any differences.
Budgeting, however, is not a substitute budget
week or a
for good management. Instead, the month
budget is an important tool of
managerial control. Managers make
decisions in budget preparation that
serve as a plan of action.
Sales and • A month, a
• The period covered by a budget varies production quarter or
according to the nature of the specific
activity involved. Cash budgets may budget a year
cover a week or a month; sales and
production budgets may cover a
month, a quarter, or a year; and the
general operating budget may cover a
quarter or a year.
General • A quarter
operating or a year
budget
THE BUDGET—FOR PLANNING AND CONTROL

• Budgeting involves the coordination of

financial and nonfinancial planning to satisfy
organizational goals and objectives. No
foolproof method exists for preparing an
effective budget. However, budget makers
should carefully consider the conditions that Top management support
follow: management levels and must be
aware of the budget’s importance.
• Top management support All management
levels must be aware of the budget’s
importance to the company and must know
that the budget has top management’s Top management must clearly state
support. Top management, then, must clearly
state long-range goals and broad objectives. long-range goals and broad objectives
These goals and objectives must be i.e. quality of products/services,
communicated throughout the organization. growth rate in sales and percentage-
Long-range goals include the expected quality of-market-targets.
of products or services, growth rates in sales
and earnings, and percentage-of-market
targets. Overemphasis on the mechanics of
the budgeting process should be avoided.
These goals and objectives must be
communicated throughout the
organization
THE BUDGET—FOR PLANNING AND CONTROL

• Participation in goal setting

Management uses budgets to show how
it intends to acquire and use resources
to achieve the company’s long-range
goals. Employees are more likely to Participation in goal setting
strive toward organizational goals if they
participate in setting them and in
preparing budgets. Often, employees
have significant information that could
help in preparing a meaningful budget.
Also, employees may be motivated to
perform their own functions within Communicating results
budget constraints if they are should be promptly
committed to achieving organizational and clearly informed
goals.
• Communicating results. People should
be promptly and clearly informed of
their progress. Effective communication Effective communication
implies (1) timeliness, (2) reasonable implies timeliness,
accuracy, and (3) improved
understanding. Managers should reasonable accuracy, and
effectively communicate results so improved understanding.
employees can make any necessary
adjustments in their performance.
THE BUDGET—FOR PLANNING AND CONTROL

• Flexibility. If significant basic

assumptions underlying the budget Flexibility involve
change during the year, the planned
operating budget should be restated. in basic
For control purposes, after the actual assumptions
level of operations is known, the actual
revenues and expenses can be underlying the
compared to expected performance at budget change
that level of operations.
• Follow-up. Budget follow-up and data
during the year
feedback are part of the control aspect
of budgetary control. Since the budgets
are dealing with projections and
estimates for future operating results Follow-up -
and financial positions, managers must
continuously check their budgets and Budget follow-up
correct them if necessary. Often and data
management uses performance reports
as a follow-up tool to compare actual feedback are part
results with budgeted results. of the control
aspect of
budgetary control
THE BUDGET—FOR PLANNING AND CONTROL

• The term budget has negative

connotations for many employees.
Often in the past, management has The term budget has negative
imposed a budget from the top without connotations for many employees
considering the opinions and feelings of
the personnel affected. Such a
dictatorial process may result in
resistance to the budget. A number of Top mgmt. not considering opinion
and feeling of affected personnel
reasons may underlie such resistance,
including lack of understanding of the
process, concern for status, and an
expectation of increased pressure to
perform. Employees may believe that Resistant to budget
the performance evaluation method is
unfair or that the goals are unrealistic
and unattainable. They may lack
confidence in the way accounting Unfair or unrealistic goals and
figures are generated or may prefer a objectives
less formal communication and
evaluation system. Often these fears are
completely unfounded, but if
employees believe these problems Lack confidence in accounting figures
exist, it is difficult to accomplish the
objectives of budgeting.
THE BUDGET—FOR PLANNING AND CONTROL

• Problems encountered with such

imposed budgets have led
accountants and management to
adopt participatory budgeting.
Participatory budgeting means
that all levels of management
responsible for actual
performance actively participate
in setting operating goals for the
coming period. Managers and
other employees are more likely
to understand, accept, and
pursue goals when they are
involved in formulating them
• Adopt participatory
budgeting
• Participatory budgeting
means that all levels of
management
responsible for actual
performance actively
participate in setting
operating goals.
THE BUDGET—FOR PLANNING AND CONTROL
• Within a participatory budgeting
process, accountants should be
compilers or coordinators of the
budget, not preparers. They should be
on hand during the preparation process
to present and explain significant
financial data. Accountants must
identify the relevant cost data that
enables management’s objectives to be
quantified in dollars. Accountants are
responsible for designing meaningful
budget reports. Also, accountants must
continually strive to make the
accounting system more responsive to
managerial needs. That responsiveness,
in turn, increases confidence in the
accounting system.
Accountants should be
compilers or coordinators of
the budget, not preparers
Accountants must identify the
relevant cost data that
enables management’s
objectives
Accountants are responsible
for designing meaningful
budget reports.
Account should make the
accounting system more
responsive to managerial
needs
THE BUDGET—FOR PLANNING AND CONTROL

• Although many companies have used

participatory budgeting successfully,
it does not always work. Studies have
shown that in many organizations,
participation in the budget
formulation failed to make Participatory budgeting
failed to make employees
employees more motivated to motivated
achieve budgeted goals. Whether or
not participation works depends on
management’s leadership style, the
attitudes of employees, and the Participation work
depends on
organization’s size and structure. management’s leadership
Participation is not the answer to all style, the attitudes of
employees, the
the problems of budget preparation. organization’s size and
However, it is one way to achieve structure

better results in organizations that

are receptive to the philosophy of
participation.
Section 2

THE STEPS IN PREPARING THE BUDGET

THE STEPS IN PREPARING THE BUDGET

• Many organizations prepare budgets that they use as a method of

comparison when evaluating their actual results over the next year.
• The process of preparing a budget should be highly regimented and follow
a set schedule, so that the completed budget is ready for use by the
beginning of the next fiscal year. Here are the basic steps to follow when
preparing a budget:
THE STEPS IN PREPARING THE BUDGET

1. Update budget assumptions.

Review the assumptions about the
company's business environment
that were used as the basis for the
last budget, and update as
necessary. Review
2. Review bottlenecks. Determine bottlenecks
the capacity level of the primary
bottleneck that is constraining the Update
budget Available
company from generating further funding
assumptions
sales, and define how this will
impact any additional company
revenue growth. Steps in
3. Available funding. Determine the budgeting
most likely amount of funding that
will be available during the budget
period, which may limit growth
plans.
THE STEPS IN PREPARING THE BUDGET

4. Step costing points. Determine

whether any step costs will be incurred
during the likely range of business
activity in the upcoming budget period,
and define the amount of these costs
and at what activity levels they will be
incurred.
Step Create
costing budget
5. Create budget package. Copy forward points package
the basic budgeting instructions from
the instruction packet used in the
Steps in
preceding year. Update it by including
budgeting
the year-to-date actual expenses
incurred in the current year, and also
annualize this information for the full
current year. Add a commentary to the
packet, stating step costing information,
bottlenecks, and expected funding
limitations for the upcoming budget
year.
THE STEPS IN PREPARING THE BUDGET

6. Issue budget package. Issue the

budget package personally, where
possible, and answer any questions from
recipients. Also state the due date for
the first draft of the budget package. Obtain
7. Obtain revenue forecast. Obtain the revenue
revenue forecast from the sales forecast
manager, validate it with the CEO, and Issue Obtain
then distribute it to the other budget department
package budgets
department managers. They use the
revenue information as the basis for
developing their own budgets. Steps in
8. Obtain department budgets. Obtain budgeting
the budgets from all departments, check
for errors, and compare to the
bottleneck, funding, and step costing
constraints. Adjust the budgets as
necessary.
THE STEPS IN PREPARING THE BUDGET

9. Obtain capital budget requests.

Validate all capital budget requests and
forward them to the senior
management team with comments and
recommendations.
Update the
10. Update the budget model. Input all budget model
budget information into the master
budget model. Obtain capital
budget Review the
11. Review the budget. Meet with the requests budget
senior management team to review the
budget. Highlight possible constraint
issues, and any limitations caused by Steps in
funding problems. Note all comments budgeting
made by the management team, and
forward this information back to the
budget originators, with requests to
modify their budgets.
THE STEPS IN PREPARING THE BUDGET

12. Process budget iterations. Track

outstanding budget change requests,
and update the budget model with new
iterations as they arrive.
13. Issue the budget. Create a bound
Issue the
version of the budget and distribute it to
all authorized recipients.
budget
Process
14. Load the budget. Load the budget Load the
information into the financial software,
budget
iterations budget
so that you can generate budget versus
actual reports.
Steps in
budgeting
Section 3

IMPORTANCE OF BUDGETING
IMPORTANCE OF THE BUDGET
The Budget serves several
purposes:
• It is a means for Executive
Management to gain consensus
on how the year’s resources are Executive
going to be allocated towards Management gain A Goal Setting
consensus on Exercise
realization of the companies resources and goals
quantifiable goals for the year.
• A Goal Setting Exercise.
• Provides a Metric for Assessing Metric for Company Acts as an Approval
Performance Process.
Company Performance.
• Acts as an Approval Process.
IMPORTANCE OF THE BUDGET-
Clearly Defined Goals
• The Financial Goals of the company
need to be defined at the beginning of
the process. A typical goal would be Clearly Defined Goals
Revenue Growth at 20%, Net Income
Growth of 10% and Departmental
Operating Expense Growth at varying
growth levels. Typically, depending on
the company, each Division/Department Effective Communication
has different growth expectations
depending on the type of company.
• Businesses that have significant
Research and Development activities, Management Involvement
for example, usually allocate a larger
amount to R&D expenses. The process
of developing the goals begins with an
analysis of the current year’s
performance and an understanding of Coordination
what relationships exist to Revenue,
fixed and variable.

Actual Performance Reporting

IMPORTANCE OF THE BUDGET-
Effective Communication
• In order for the Management Team to
be able to translate the goals into an
Operating Budget, effective Clearly Defined Goals
communication is imperative. First, a
timetable needs to be developed to set
expectations and to determine
deadlines. A company meeting to
communicate the process is desirable to Effective Communication
ensure everyone receives the same
message. A budget package is
distributed to management with
information to help develop budgets. Management Involvement
The package should contain a rolling
forecast updated with actuals,
employee detail for headcount
planning, the defined goals with
specifics related to each department, a
digital worksheet to aid both the Coordination
development of the budget and any
upload or consolidation process, and a
financial calendar which includes
deadlines and responsibilities. Actual Performance Reporting
IMPORTANCE OF THE BUDGET-
Management Involvement
• For the process to be effective,
Management buy-in is essential both in
the planning process and during the Clearly Defined Goals
year to monitor and manage actual
performance. One purpose of the
budgeting exercise is to achieve
consensus by everyone even though
they are all competing for the same Effective Communication
resources. It is not possible for everyone
to be able to add all the headcount they
desire or spend the amount of money
they would prefer. In addition, each Management Involvement
department has a different perspective
on what is necessary to achieve the
company’s goals and the importance of
their contribution. By the end of the
process, everyone will have had to
compromise and should understand Coordination
where their interests all intersect with
the company’s goals.
Actual Performance Reporting
IMPORTANCE OF THE BUDGET-
Coordination
• Someone needs to be in charge of
the process and drive towards the
deadlines. It is common for it to fall Clearly Defined Goals
within the Chief Financial Officer’s
responsibilities. Absent that position,
at the direction of the COO it usually
belongs in the Controller’s Effective Communication
responsibilities. Preparing the
information for goal setting, creating
the worksheets, consolidating the
information and being available to Management
facilitate the process are all Involvement
responsibilities of this position.

Actual Performance Reporting

IMPORTANCE OF THE BUDGET-
Actual Performance Reporting
• Important to the effectiveness of the
process is regular comparison of
actual performance to the budget. In Clearly Defined Goals
addition to the inclusion of budgets in
the financial statement comparisons,
many decisions should be made with Effective Communication
the budget in mind. For example,
headcount additions and fixed asset
acquisitions should be evaluated if Management Involvement
they were not budgeted expenses.
• Many companies allow expenditures
that were approved in the budget
process but require extensive Coordination
justification if they were not.

Actual Performance Reporting

Section 4

INTRODUCTION TO CAPITAL BUDGETING

CAPITAL BUDGETING

• Capital budgeting, which is also called “investment appraisal,” is the

planning process used to determine which of an organization’s long term
investments such as new machinery, replacement machinery, new plants,
new products, and research development projects are worth pursuing. It is
to budget for major capital investments or expenditures.
CAPITAL BUDGETING METHODS

Many formal methods are used

in capital budgeting, including
Net present value
the techniques as followed:
• Net present value
Internal rate of return
• Internal rate of return
• Payback period Payback period
• Profitability index
• Equivalent annuity Profitability index

• Real options analysis

Equivalent annuity

Real options analysis

NET PRESENT VALUE

• Net present value (NPV) is used to

estimate each potential project’s
value by using a discounted cash
flow (DCF) valuation. This valuation
requires estimating the size and
timing of all the incremental cash
flows from the project. The NPV is
greatly affected by the discount rate,
so selecting the proper rate–
sometimes called the hurdle rate–is
critical to making the right decision.
This should reflect the riskiness of the
investment, typically measured by
the volatility of cash flows, and must
take into account the financing mix.
INTERNAL RATE OF RETURN

• The internal rate of return (IRR) is

defined as the discount rate that
gives a net present value (NPV)
of zero. It is a commonly used
measure of investment efficiency.
• The IRR method will result in the
same decision as the NPV
method for non-mutually
exclusive projects in an
unconstrained environment, in
the usual cases where a negative
cash flow occurs at the start of
the project, followed by all
positive cash flows. Nevertheless,
for mutually exclusive projects,
the decision rule of taking the
project with the highest IRR,
which is often used, may select a
project with a lower NPV.
PAYBACK PERIOD

• Payback period in capital

budgeting refers to the period of
time required for the return on
an investment to “repay” the
sum of the original investment.
Payback period intuitively
measures how long something
takes to “pay for itself. ” All else
being equal, shorter payback
periods are preferable to longer
payback periods.
• The payback period is considered
a method of analysis with serious
limitations and qualifications for
its use, because it does not
account for the time value of
money, risk, financing, or other
important considerations, such as
the opportunity cost.
PROFITABILITY INDEX
• Profitability index (PI), also
known as profit investment ratio
(PIR) and value investment ratio
(VIR), is the ratio of payoff to
investment of a proposed
project. It is a useful tool for
ranking projects, because it
allows you to quantify the
amount of value created per unit
of investment.
EQUIVALENT ANNUITY

• The equivalent annuity method

expresses the NPV as an
annualized cash flow by dividing
it by the present value of the
annuity factor. It is often used
when comparing investment
projects of unequal lifespans. For
example, if project A has an
expected lifetime of seven years,
and project B has an expected
lifetime of 11 years, it would be
improper to simply compare the
net present values (NPVs) of the
two projects, unless the projects
could not be repeated.
REAL OPTIONS ANALYSIS

• The discounted cash flow methods

essentially value projects as if they were
risky bonds, with the promised cash
flows known. But managers will have
many choices of how to increase future
cash inflows or to decrease future cash
outflows. In other words, managers get
to manage the projects, not simply
accept or reject them. Real options
analysis try to value the choices–the
option value–that the managers will
have in the future and adds these
values to the NPV.
• These methods use the incremental
cash flows from each potential
investment or project. Techniques based
on accounting earnings and accounting
rules are sometimes used. Simplified
and hybrid methods are used as well,
such as payback period and discounted
payback period.
THE GOALS OF CAPITAL BUDGETING

Capital Budgeting, as a part of

budgeting, more specifically
focuses on long-term
investment, major capital and
capital expenditures. The main
goals of capital budgeting
Ranking Projects
involve:
1. Ranking Projects
2. Raising funds Raising funds
RANKING PROJECTS
• The real value of capital
budgeting is to rank projects.
Most organizations have many
Lowest
projects that could potentially be Profitability
financially rewarding. Once it has index
been determined that a
particular project has exceeded
its hurdle, then it should be
ranked against peer projects (e.g.
highest Profitability index to
lowest Profitability index). The
highest ranking projects should
be implemented until the Highest
budgeted capital has been Profitability
expended. index
RAISING FUNDS

• When a corporation determines

its capital budget, it must acquire Corporate
funds. Three methods are
generally available to publicly- bonds
traded corporations: corporate
bonds, preferred stock, and
common stock. The ideal mix of
those funding sources is Preferred
determined by the financial
managers of the firm and is
stock
related to the amount of financial
risk that the corporation is willing
to undertake.
Common
stock
RAISING FUNDS

• Corporate bonds entail the lowest

financial risk and, therefore,
generally have the lowest interest
rate. Preferred stock have no
financial risk but dividends, including
all in arrears, must be paid to the
preferred stockholders before any
cash disbursements can be made to
common stockholders; they generally
have interest rates higher than those
of corporate bonds. Finally, common
stocks entail no financial risk but are
the most expensive way to finance
capital projects. The Internal Rate of
Return is very important.
Corporate bond- lowest
financial risk and lowest
interest rate.
Preferred stock have no
financial risk but
dividends, higher interest
rate than corporate bond.
Common stock has no
financial risk but most
expensive way to finance
capital projects
RAISING FUNDS

• Capital budgeting is an important

task as large sums of money are
involved, which influences the
profitability of the firm. Plus, a long-
term investment, once made, cannot Capital Long-term
be reversed without significant loss of budgeting investment
invested capital. The implication of decisions are decisions are
long-term investment decisions are subject to a more
more extensive than those of short-
higher degree extensive than
run decisions because of the time
factor involved; capital budgeting
of risk and those of short-
decisions are subject to a higher uncertainty run decisions
degree of risk and uncertainty than than are short-
are short-run decisions. run decisions
ACCOUNTING FLOWS AND CASH FLOWS

• Capital budgeting requires a thorough understanding of cash flow

and accounting principles, particularly as they pertain to valuing
processes and investments.
ACCOUNTING FLOWS

• Accounting is the processes used

to identify and transpose
business transactions into
permanent legal records of a
business’s operations and capital
flows. The International
Accounting Standards (IAS) and
the Generally Accepted
Accounting Principles (GAAP) are
legislative descriptions of
expectations and norms within
the accounting field.
ACCOUNTING FLOWS

Accounting Flows: This chart is a useful way to see the trajectory of accounting
flows as they apply to different types of line items.

Understanding how to report each type of asset, and the impacts these asset
changes have on income statements, balance sheets, and cash flow statements,
is important in accurately depicting accounting flows.
CASH FLOWS

• A cash flow is one element of

accounting flows, and particularly
important to understanding
capital budgeting. A cash flow
describes the transmission of
payments and returns internally
and/or externally as a byproduct
of operations over time. A cash flow describes the
Conducting cash flow analyses on transmission of payments
current or potential projects and and returns internally and/or
investments is a critical aspect of externally as a byproduct of
capital budgeting, and
determines the profitability, cost operations over time
of capital, and/or expected rate
of return on a given project,
organizational operation or
investment.
CASH FLOWS

• Cash flow analyses can reveal the

rate of return, or value of
suggested project, through
deriving the internal rate of
return (IRR) and the net present
value (NPV). They also indicate
overall liquidity, or a business’s
capacity to capture existing
opportunities through freeing of
capital for future investments.
Cash flows will also underline
overall profitability including, but
not limited to, net income.
CASH FLOWS
Cash flows consolidate inputs
from the following activities:
• 1. Investing activities
• 2. Operating activities
• 3. Financing activities
• Investing activities – Payments
related to mergers or
acquisitions, loans made to
suppliers or received from
customers, as well as the
purchase or sale of assets are all
considered investing activities
and tracked as incoming or
outgoing cash flows.
CASH FLOWS
Cash flows consolidate inputs
from the following activities:
• 1. Investing activities
• 2. Operating activities
• 3. Financing activities
• Operating activities – Operating
activities can be quite broad,
incorporating anything related to
the production, sale, or delivery
of a given product or service. This
includes raw materials,
advertising, shipping, inventory,
payments to suppliers and
employee, interest payments,
depreciation, deferred tax, and
amortization.
CASH FLOWS
Cash flows consolidate inputs
from the following activities:
• 1. Investing activities
• 2. Operating activities
• 3. Financing activities
• Financing activities – Financing
activities primarily revolve
around cash inflows from banks
and shareholders, as well as
outflows via dividends to
investors. This includes, payment
for repurchase of company
shares, dividends, net borrowing
and net repayment of debt.
RANKING INVESTMENT PROPOSALS

• Several methods are commonly Net Present Value (NPV)

used to rank investment
proposals, including NPV, IRR, PI, Internal rate of return (IRR)
payback period, and ARR.
• The explanation was discussed
Profitability Index (PI)
earlier in previous slides
Payback period