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Sandeep Vilas Shirsekar

Batch 13 B Roll No 93
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Budgeting
* INTRODUCTION
* TYPES
* METHODS

Capital Budgeting
Working Capital Management

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INTRODUCTION:
For effective running of a business, management must
know:
• where it intends to go i.e. organizational objectives
• how it intends to accomplish its objective i.e. plans
• whether individual plans fit in the overall
organizational objective. i.e. coordination
• whether operations conform to the plan of
operations relating to that period i.e. control
“Budgetary control is the device that a company
uses for all these purposes.”
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WHAT IS A BUDGET?
“ A plan expressed in money. It is
prepared and approved prior to the
budget period and may show income,
expenditure and the capital to be
employed. May be drawn up showing
incremental effects on former
budgeted or actual figures, or be
compiled by Zero-based budgeting.”
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WHAT IS BUDGETARY CONTROL?
Budgetary control is the use of the comprehensive system of
budgeting to aid management in carrying out its functions like
planning, coordination and control.
This system involves:
 Division of organization on functional basis into different
sections known as a budget centre.
 Preparation of separate budgets for each “budget centre”.
 Consolidation of all functional budgets to present overall
organizational objectives during the forthcoming budget period.
 Comparison of actual level of performance against budgets.
 Reporting the variances with proper analysis to provide basis
for future course of action.
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CLASSIFICATION OF BUDGETS

ACCORDING TO ACCORDING TO ACCORDING TO


TIME FUNCTION FLEXIBILITY

• Long term budget 1. Sales budget 1. Fixed budget


• Short term budget 2. Production budget 2. Flexible
budget
• Current budget 3. Cost of Production budget
• Rolling budget 4. Purchase budget
5. Personnel budget
6. R & D budget
7. Capital Expenditure budget
8. Cash budget
9. Master budget

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1. SALES BUDGET:
Sales budget is the most important budget based on which all the
other budgets are built up. This budget is a forecast of quantities
and values of sales to be achieved in a budget period.

2. PRODUCTION BUDGET:
Production budget involves planning the level of production which
in turn involves the answer to the following questions:
a. What is to be produced?
b. When is it to be produced?
c. How is it to be produced?
d. Where is it to be produced?

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3. COST OF PRODUCTION BUDGET:
This budget is an estimate of cost of output planned for a
budget period and may be classified into –
• Material Cost Budget
• Labour Cost Budget
• Overhead Cost Budget

4. PURCHASE BUDGET:
This budget provides information about the materials to be
acquired from the market during the budget period.

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5. PERSONNEL BUDGET:
This budget gives an estimate of the requirements of
direct labour essential to meet the production target.
This budget may be classified into –
a. Labour requirement budget
b. Labour recruitment budget
6. RESEARCH AND DEVELOPMENT BUDGET:
This budget provides an estimate of expenditure to be
incurred on R & D during the budget period.
A R&D budget is prepared taking into consideration the
research projects in hand and new R & D projects to be
taken up.
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7. CAPITAL EXPENDITURE BUDGET:
This is an important budget providing for acquisition of
assets necessitated by the following factors:
a. Replacement of existing assets.
b. Purchase of additional assets to meet increased production
c. Installation of improved type of machinery to reduce
costs.
8. CASH BUDGET:
This budget gives an estimate of the anticipated receipts and
payments of cash during the budget period.
Cash budget makes the provision for minimum cash
balance to be maintained at all times.
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9. MASTER BUDGET:
CIMA defines this budget as “ The summary budget incorporating
its component functional budget and which is finally approved,
adopted and employed”.
Thus master budget is a summary of all functional budgets in
capsule form available in one report.
10. FIXED BUDGET:
This is defined as a budget which is designed to remain
unchanged irrespective of the volume of output or turnover
attained.
This budget will, therefore, be useful only when the actual level of
activity corresponds to the budgeted level of activity.

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11. FLEXIBLE BUDGET:
CIMA defines this budget as one “ which, by recognising the
difference in behaviour between fixed and variable costs in
relation to fluctuations in output, turnover or other variable
factors such as number of employees, is designed to change
appropriately with such fluctuations”.

12. PERFORMANCE BUDGETING:


These days budgets are established in such a way so that each
item of expenditure is related to specific responsibility centre
and is closely linked with the performance of that standard.

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13. ZERO BASE BUDGETING:
The zero base budgeting is not based on the incremental
approach and previous figures are not adopted as the base.

Zero is taken as the base and a budget is developed on the


basis of likely activities for the future period.

A unique feature of ZBB is that it tries to help


management answer the question, “Suppose we are to start
our business from scratch, on what activities would we spent
out money and to what activities would we give the highest
priority?”

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14. RESPONSIBILITY ACCOUNTING:
Responsibility accounting fixes responsibility for cost control
purposes by establishing responsibility centres namely –
a. Cost centre
b. Profit centre
c. Investment centre
Principles of responsibility accounting are as follows:
1. Fixation of targets for each responsibility centre
2. Actual performance is compared with the target
3. The variances therein are analyzed so as to fix the
responsibility of centres.
4. Taking corrective action.
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CONCLUSION:

Ψ Preparation of budgets is the first step in the budgetary


control system.
Ψ Implementation of budgets is the second phase.
Ψ But preparation and implementation of budgets alone
will not achieve much unless a comparison is made
regularly between the actual performance and the
budgeted performance.
Ψ Continuous and proper reporting makes this possible.
Ψ To ensure the success of budgetary control system,
proper follow up action has to be taken immediately for the
reports submitted.
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CAPITAL BUDGETING

Capital budgeting is a decision situation where large funds


are committed (invested) in the initial stages of the project
and the returns are expected over a long period of time.
These decisions are related to allocation of investible funds
to different long-term assets.

Capital budgeting is a continuous process and it is carried


out by different functional areas of management such as
production, marketing, engineering, financial management
etc.
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BASIC FEATURES OF CAPITAL
BUDGETING

 Capital budgeting decisions have long-term


implications.
 These decisions involve substantial commitment of
funds.
 These decisions are irreversible and require analysis
of minute details.
 These decisions determine and affect the future
growth of the firm.

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CAPITAL BUDGETING
DECISION INVOLVES
THREE STEPS

• Estimation of costs and benefits of a proposal or of


each alternative.
• Estimation of the required rate of return, i.e., the cost
of capital
• Selection and applying the decision criterion.

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1. ESTIMATION OF CASH FLOWS

The costs and benefits for a capital budgeting


decision situation are measured in terms of cash
flows.
An important point is that all cash flows are
considered on after tax basis. The rule is that all
financial decisions are subservient to tax laws.
The cash flow from the project are compared with the
cost of acquiring the project.

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The cash flows may be grouped into relevant and

irrelevant cash flows as follows:


Relevant cash flows Irrelevant cash flows
• Cost of new project Sunk cost
• Scrap value of old / new plant Allocated overheads
• Trade-in-value of old plant Financial cash flows
• Cost reduction / savings
• Effect on tax liability
• Incremental repairs
• Working capital flows
• Revenue from new proposal
• Tax benefit of incremental
depreciation 21
Calculation of different cash flows may be summarized as
follows:
INITIAL CASH OUTFLOW:
Cost of new plant
+ Installation expenses
+ Other Capital expenditure
+ Additional working capital
– Tax benefit on account of capital loss on sale of old
plant (if any)
– Salvage value of old plant + Tax liability on account of
capital gain on sale of old plant (if any).
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SUBSEQUENT ANNUAL INFLOWS:
Profit after tax
+ Depreciation
+ Financial charge ( 1-t)
– Repairs (if any)
– Capital Expenditure (if any).

TERMINAL CASH FLOW:


Annual cash inflow
+ Working capital released
+ Scrap value of the plant (if any).
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2. DECISION CRITERIA
TECHNIQUES OF EVALUATION

Traditional or Time-adjusted or
Non-discounting Discounted cash flows

1. Payback period 1. Net Present Value


2. Accounting Rate of 2. Profitability Index
Return 3. Internal Rate of Return
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TRADITIONAL OR NON-DISCOUNTING
TECHNIQUES

I . PAYBACK PERIOD:
# The payback period is defined as “the number of
years required for the proposal’s cumulative cash inflows to be
equal to its cash outflows.”
# The payback period is the length of time required
to recover the initial cost of the project.
# The payback period may be suitable if the firm
has limited funds available and has no ability or willingness to
raise additional funds.
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II . ACCOUNTING RATE OF RETURN (OR) AVERAGE

RATE OF RETURN
(ARR)
# The ARR may be defined as “the annualized net
income earned on the average funds invested in a project.”
# The annual returns of a project are expressed as a
percentage of the net investment in the project.

COMPUTATION OF ARR:

Average Annual profit (after tax)


ARR = x 100
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DISCOUNTED CASH FLOWS OR TIME
ADJUSTED TECHNIQUES

These are based upon the fact that the cash flows occurring at
different point of time are not having same economic worth.

I. NET PRESENT VALUE (NPV) METHOD:


The NPV of an investment proposal may be defined as the sum of the
present values of all the cash inflows less the sum of present values of all
the cash outflows associated with the proposal. The decision rule is “
Accept the proposal if its NPV is positive and reject the proposal if the
NPV is negative”.

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II. PROFITABILITY INDEX METHOD:
This technique is a variant of the NPV technique and is also
known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.

Total present value of cash inflows


PI =
Total present value of cash outflows.

Accept the project if its PI is more than 1 and reject


the proposal if the PI is less than 1.

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III. INTERNAL RATE OF RETURN (IRR) METHOD:
 The IRR of a proposal is defined as the discount rate which
produces a zero NPV, i.e., the IRR is the discount rate which will
equate the present value of cash inflows with the present value of
cash outflows.

 The IRR is also known as Marginal Rate of Return or


Time Adjusted Rate of Return.

 The time-schedule of occurrence of future cash flows is


known but the rate of discount is not.

 The discount rate calculated will equate the present value of


cash inflows with the present value of cash outflows.
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CAPITAL BUDGETING PRACTICES IN INDI
Capital budgeting decisions are undertaken at the top
management level and are planned in advance. The Corporates
follow mostly top-down approach in this regard.
Discounted cash flow techniques are more popular now.
High growth firms use IRR more frequently whereas
Payback period is more widely used by small firms.
PI technique is used more by public sector units than by
private sector units.

Capital budgeting decisions are of paramount


importance as they affect the profitability of a firm,
and are the major determinants of its efficiency and
competing power.
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WORKING CAPITAL MANAGEMENT
Working capital management is concerned with the
problems that arise in managing the current assets,
current liabilities and the interrelationships between
them.
GOAL:
To manage the firm’s current assets and liabilities
in such a way that a satisfactory level of working
capital is maintained.

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CONCEPTS:

GROSS WORKING CAPITAL – The current assets which


represent the proportion of investment that circulates
from one form to another in the ordinary conduct of
business.

NET WORKING CAPITAL – The portion of current


assets financed with long term funds or current assets –
current liabilities

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PURPOSE:
The NWC is necessary because the cash outflows and inflows do not
coincide.
The purpose of NWC is to measure the liquidity of the firm.

DETERMINING FINANCING MIX:


Financing mix is the choice of sources of financing of current assets.

SOURCES OF ASSET FINANCE:


1. Short term sources (Current liabilities)
2. Long term sources (Share capital, long term borrowings).

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INSTRUMENTS OF SHORT TERM
FINANCING

ǿ Trade Credit
ǿ Bill Discounting
ǿ Inter Corporate Deposits
ǿ Public deposits
ǿ Commercial papers
ǿ Factoring

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APPROACHES TO DETERMINE
FINANCING MIX

1. Hedging approach
2. Conservative approach
3. Trade off between the above
mentioned two approaches.

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HEDGING APPROACH
(MATCHING APPROACH)
This is the process of matching maturities of debt
with the maturities of financial needs.
According to Hedging approach, the permanent
portion of funds required should be financed with
long term funds and the seasonal portion with
short term funds.
Under this approach working capital = 0 since CA
are not financed by long term funds (CA = CL).

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CONSERVATIVE FINANCING APPROACH:
This is a strategy by which the firm finances all funds
requirement, with long term funds and uses short term
funds for emergencies or unexpected outflows.
TRADE OFF BETWEEN HEDGING AND
CONSERVATIVE APPROACHES:
One possible trade off could be equal to the average of the
minimum and maximum monthly requirements of funds
during the given period of time. This level of requirement
of funds may be financed through long run sources and
for any additional financing need, short term funds may be
used.

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FACTORS DETERMINING AMOUNT OF WORKING CAPITAL

Purchase Payment for Sell product Receive


resources resource purchase on credit cash

Inventory Receivable
conversion conversion
period period

Payables Cash
period Conversion
period
Operating cycle 39
 The ‘length of the operating cycle’ is the most
widely used method to determine working capital need.
 The longer the production cycle, the larger is the
working capital need or vice versa.
 Manufacturing and trading enterprises require fairly
large amount of working capital to support their
production and sales activity. Service enterprises like
hotels, restaurants etc., need less working capital.
 During boom conditions need for working capital is
more.
 Growth industries and firms need more working
capital.
 Working capital requirement are to be determined
on the basis of cash cost i.e excluding depreciation.

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