capital planning and budgeting nur aini masruroh //aini.staff.ugm.ac.id/ ; email: [email protected];...
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Capital Planning and Budgeting
Nur Aini Masruroh
http://aini.staff.ugm.ac.id/ ; Email: [email protected]; [email protected]
Introduction Series of decisions by individual economic units as to
how much and where resources will be obtained and expended for future use, particularly in the production of future goods and services
Decide by the highest level of management
Scope: How the money is acquired and from what resources How individual capital project opportunities (and
combination of opportunities) are identified and evaluated
How minimum requirements of acceptability are set How final project selections are made How postmortem reviews are conducted
Sources of funds Internal sources
Retained earnings Reinvested depreciation reserves
External sources Choose especially when it is judged to be in the
best interests of the existing stockholders In general, the more attractive the investment
proposal available, the more the company be willing to go to outside sources to obtain capital in order to take advantage of more investments
Equity
0
20
40
60
80
100
Delta
AirSears
Texas
Instr
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Coca
Cola
Kodak
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Equity Creditor
J.J. Wild, L.A. Bernstein, K.R. Subramanyan, 2001, Financial Statement Analysis, McGraw Hill Book Co, New York.
Identification and evaluation of opportunities All levels of the organization should be
encouraged to develop proposals for capital investment projects
Good proposals indicate good company environment Determine how the company can survive
Minimum requirements of acceptability Determining MARR is generally controversial and
difficult Maximize the economic well-being of the present
owner It is common to set more than one MARR
according to risk categories, for example: High risk (MARR 40%)
New products, new business, acquisitions, joint ventures Moderate risk (MARR 25%)
Capacity increase to meet forecasted sales Low risk (MARR 15%)
Cost improvements, make versus buy, capacity increase to meet existing orders
Project selection Choose the projects that offer highest
prospective profitability subject to allowances for intangibles or nonmonetary considerations, risk considerations, and limitation of the capital
If MARR has been determined correctly, choose the proposal according to the value of rate of return, PW, AW, or FW
Consider: Classification of the proposal
Level of applications, activity, benefit, priority, resources used, etc
Dependency between projects Prerequisite, mutually exclusive, independent, substitute,
complement, etc
Organization for capital planning and budgeting The levels required for approval should
depend on the nature and importance of the individual project
Illustration: If the total investment required for the project is
$50 ≤ investment ≤ $ 1,000, approval is required through plant manager
$1000 < investment ≤ $ 10,000, approval is required through division vice president
$10,000 < investment ≤ $ 25,000, approval is required through president
$ 25,000 ≤ investment, approval is required through board of director
Post mortem review Three main purposes (at least):
It determines if planned objectives have been obtained
It determines if corrective action is required It improves estimating and future planning
Mathematical programming for capital budgeting Consider:
m new independent, indivisible investment opportunity are available
Investment opportunity i has a worth of pi (can be positive or negative), an initial investment of ci, and annual operating and maintenance cost of ai.
There exists a capital budget limitation of $C for new investments, $A for total annual operating and maintenance cost
Mathematical programming for capital budgeting (cont’d)
m1,...,i1or0
sconstraintcostemaintenancandoperatingAnnual,...,1
sconstraintCapital,...,1
tosubject
max
otherwise0
selectedisinvestmentIf1Let
1
1
1
i
m
iii
m
iii
m
iii
i
x
mjAxa
miCxc
xpz
ix
Example A firm is considering two different computing systems
and , three different software packages. Software packages 1 and 2 can be used only on computing system I, software package 3 can be used on either computing system. Alternatively, the firm can developed its own software. In this instance the following investment opportunities are defined to meet objective of minimizing Purchase computing system I Purchase computing system II Purchase software package 1 Purchase software package 2 Purchase software package 3 Prepare own software package
Independent collections of mutually exclusive opportunities
1 …2 n1
i1
1 …2 nm
im
….
Source i (i=1,2,…,m)
Opportunity j
(j=1,2,…,ni)
Sources are independent and opportunities are mutually exclusive
Define:
m = number of sources of investment opportunities
ni = number of mutually exclusive investment opportunities available from source i
pij = present worth of investment opportunity j from source i
C = budget limit
Independent collections of mutually exclusive opportunities (cont’d)
jix
mix
Cxc
xpz
ijx
ij
n
jij
m
i
n
jijij
m
i
n
jijij
ij
i
i
,1or0
,...,11
tosubject
max
otherwise0
selectedissourcefromyopportunitinvestmentIf1Let
1
1 1
1 1
Divisible investment opportunities In some cases, investment opportunities are
divisible, instead of totally “do nothing” or “do all”
Can be formulated as LP using continuous decision variables; others can be formulated as ILP
Plant Budget category Rate of return Maximum investmentIn million $
1 123
16%12%14%
121018
2 456
20%12%10%
126
14
3 78
16%18%
208
Example A major industrial firm has $60 million available for the coming year to be allocated among three processing plants. Because of personnel levels and ongoing projects at the plants, it is necessary that at least $6 million be allocated to plant 1, $16 million to plant 2, and $10 million to plant 3. Because of the production facilities available at plant 3, no more than $34 million can be utilized without major new capital expansion; such expansion cannot be taken at this time. A number of investment opportunities exist at the various plants. Each plant has submitted budget requests in which the opportunities are grouped into categories by anticipated rate of return. For simplicity, the rate of return is expressed as a percentage of investment.
Capital rationing Number of sources of investment funds may be available There are some investment opportunities Each dollar borrowed from source j cost cj
Each dollar invested in investment opportunity i returns ri
The dollar amount available from source j is denoted by bj
The maximum amount that can be invested in opportunity i is denoted as ai
The net return resulting from borrowing a dollar from source j and investing it in opportunity i is denoted cij=ri – cj
The amount borrowed from source j and invested in opportunity i is denoted xij
To ensure that the money will not be invested unless it is profitable to do so, a dummy source of funds is defined as
To ensure that the money will not be borrowed unless it is profitable to do so, a dummy source of funds is defined as
0and ,11
1
jm
n
jjm cba
0and 1,1
1
ni
m
iin cab
Capital rationing (cont’d) Can be formulated as transportation problem
jandiallforx
miax
njbx
tosubject
xcz
ij
i
n
jij
j
m
iij
m
i
n
jijij
0
1,...,1
1,...,1
max
1
1
1
1
1
1
1
1