Capital Budgeting Subhan

8/16/2019 Capital Budgeting Subhan

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Contents

1 CAPITAL FINANCING IN SME..................................................................................3

1.1 Business life cycle:.........................................................................................3

1.1.1 Stage 1: Stat!u":....................................................................................#

1.1.$ Stage $: Ealy go%t&:.............................................................................#

1.1.3 Stage 3: Ta'e!o(:..................................................................................... )

1.1.# Stage #: Matuity:....................................................................................)

1.$ Finance ga":...................................................................................................*

1.$.1 Long!te+ ,e-t:.......................................................................................*

1.$.$ Euity:..................................................................................................... *

1.$.3 Flotation of s+all -usinesses:..................................................................*$ CAPITAL B/0GETING IN TE SME:........................................................................2

$.1 Ca"ital Bu,geting T&eoy an, S+all Fi+s:...................................................

$.$ Ca"ital Bu,geting Assu+"tions an, t&e S+all an, +e,iu+ ente"ises:......4

$.3 Po5ect E6aluation Met&o,s in SME:.............................................................17

$.3.1 Gut feel:.................................................................................................17

$.3.$ Pay-ac' "eio,:..................................................................................... 11

$.3.3 Accounting ate of etun:......................................................................11

$.3.# 0iscounte, cas& 8o% analysis:..............................................................1$

$.3.) Co+-ination of +et&o,s:...................................................................... 1$

$.# Su++ay:.................................................................................................... 13

$.) T&e I+"otance of Ca"ital Bu,geting in cuent scenaio:...........................1#

$.).1 0e6elo" an, fo+ulate long!te+ stategic goals:................................1#

$.).$ See' out ne% in6est+ent "o5ects:........................................................1#

$.).3 Esti+ate an, foecast futue cas& 8o%s:...............................................1#

$.).# Facilitate t&e tansfe of info+ation:....................................................1#

$.).) Ceation of 0ecision:.............................................................................1)

3 TE EFFECTS 9F CAPITAL B/0GETING TECNI/ES 9N TE G;9


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3.# Long te+ E(ect on Po=ta-ility:..................................................................1*

3.) Ma>i+i?e t&e o%nes@ euity:......................................................................1*

3.* National I+"otance:................................................................................... 1*

# ;EFE;ENCES:..................................................................................................... 12

TOPIC: A) TYPICAL CAPITAL FINANCING ANDCAPITAL BUDGETING IN SME AND IMPORTANCE OFTHESE FACTORS ON IN CURRENT SCENARIO


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TOPIC: B) OWN POINT OF VIEW ON THE EFFECTSOF CAPITAL BUDGETING TECHNIQUES ON THE

GROWTH OF MICRO FINANCE ENTERPRISES

1 CAPITAL FINANCING IN SME

The SME sector ranges from the one-person sole trader to the manufacturing company with 199

employees. A large proportion of SMEs are, however, very small, having less than employees.

!hen it comes to financing, the very small firms, and many of the remaining small firms which

do not intend to grow, tend to rely heavily on the e"uity and de#t supplied #y the founders,

friends, relatives, private #ac$ers, and trade credit, and de#t from the capital mar$et %especially

from #an$s&.

Although financial pro#lems figure largely in the reasons for the failure of such firms, these are

pro#a#ly due more to lac$ of information and incompetence on the part of owner-managers than

the unavaila#ility of finance.

1.1 Businss !i" #$#!:There are an important, although small, proportion of SME operators who are growth-motivated

and have an enterprise that can grow. Such firms tend to have a #usiness life cycle with

commensurate financing needs. See in the following 'igure, which has one a(is indicating time

and the other a(is with a measure of SME growth %such as sales&.


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1.1.1 S%&' 1:

S%&(%u*:

At the start-up stage

the ma)or source of finance is li$ely to #e the private resources of the starter. These will tend to

#e limited, even when supplemented in some cases #y loans from friends, relatives and the

occasional private #ac$er. *nder-capitali+ation is a common cause of a crisis in Stage 1 with

su#se"uent failure. Trade credit will often #ecome availa#le, and de#t from financial institutions

such as #an$s will only #e availa#le if the owner has collateral security, such as a home or other

property.

1.1.+S%&' +: E&(!$ '(,-%:

Early growth occurs as production, sales or services and a mar$et develop. Staff, often part-time

or casual, will #e added. remises may #e rented and e"uipment leased. nly limited funds come

from retained earnings. Although future prospects may #e #right %#ut uncertain&, the trac$ record

of the #usiness is limited and collateral security and personal guarantees have #een fully utili+ed

to o#tain short-term and medium-term de#t, mainly from trading #an$s.

n these stages %and Stage /& owners often resort to 0#ootstrapping, that is, alternative means of

securing resources that do not re"uire traditional funding. They ac"uire resources from customers

and suppliers as well as using their own resources. They #uy used e"uipment, withhold staff

salaries, accelerate invoicing, negotiate conditions with suppliers, delay payment to suppliers,

and #orrow e"uipment from other #usinesses.


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Stages 1 and 2 comprise the esta#lishment or infant stage of growth, perhaps three years of

critical development #efore the firm goes through the 0$nothole into Stage /, or closes.

1.1./S%&' /: T&0,:

nto the ta$e-off stage a trac$ record has #een esta#lished for the a#ility of the owner and thesuccess of the product or service. Turnover increases rapidly and pro)ections for future growth

are strong. 3ong-term funds #ecome essential, especially for wor$ing capital, #ut here is the

pro#lem for the #usiness.

4etention is limited #ecause although accounting profits may #e growing, cash flow is low and is

needed to fund wor$ing capital. There is no proven )unior share mar$et for the flotation of

growing SMEs, and few investors are willing to purchase minority e"uity positions in unlisted

companies. 3ong-term de#t is very hard to o#tain from traditional sources, especially as the firmhas fully utili+ed its collateral security and the personal guarantees of owners.

This is the growth stage in which good financial management is a#solutely critical.

ncompetence in financial management as well as the financing difficulties can create a li"uidity

crisis and li$ely failure, especially if the firm was under-capitali+ed at inception #ut managed to

continue to Stage /.

1.1.2S%&' 2: M&%u(i%$:

!ith ade"uate financial management and the ac"uisition of long-term finance, the firm may

continue to grow to a sufficient si+e to float on the AS5. E"uity then #ecomes availa#le as well

as a variety of other funds, and if it has not already done so, it soon )oins the 6ig 6usiness class.

ur stage model is much generali+ed, #ut it is sufficiently helpful to indicate the three trou#le

spots in Australia for the financing of growth SMEs7

There is a shortage of long-term de#t, especially in Stage /.

There is a shortage of e"uity in Stages 1 and /.

There may #e an insufficient proportion of SMEs which proceed to pu#lic flotation in

Stage 8.

1.+ Fin&n# '&*:n loo$ing more closely at these three financing aspects, there is a finance gap in Australia for

SMEs.


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1.+.1L,n'%(3 45%:

n a 1991 survey #y the 6ureau of ndustrial Economics of the sources of finance for

manufacturing small #usinesses, more than :; of the firms received de#t from #an$s, which

provide little long-term de#t. The predominant forms of de#t were mainly at-call de#t %#an$

overdraft&, short term #ills and traditional medium-term de#t %term loans and finance leases&.

There was limited use of other sources and forms of de#t. There are two aspects of the de#t gap.

1.2.1.1 The frst is a lack o long-term debt:

Separately from residential mortgages, commercial #an$ de#t is limited to term loans or leases of

three to five years or occasionally seven years.

1.2.1.2 Caused by the act:

The second aspect is caused #y the fact that not all small firms can provide collateral security

re"uired #y #an$s for de#t finance.

1.+.+E6ui%$:

3arge listed companies o#tain their e"uity from financial institutions, overseas investors, other

companies and private individuals. Small companies see$ing e"uity have a more restricted set of

options. A#out :; comes from owners or related family, only 2.; from financial institutions

and effectively nil from overseas investors. ndividual investors and other #usinesses provide

minimal e"uity.


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To counter such pro#lems, second #oards were esta#lished #y the stoc$ e(changes in each state

#etween 198 and 19>. Activity pea$ed on the second #oards in 19>?@listed companies

had a mar$et value of B2,>:: million, #ut following the share mar$et crash of cto#er 19@ and

the su#se"uent economic recession, the new #oards collapsed. These second #oards were

discontinued from /: Cune 1992. The Dewcastle Stoc$ E(change %DS5& reactivated in 2::: and

the 6endigo Stoc$ E(change %6SE& revived in 2::1 to provide for small listings are yet to

achieve general acceptance and a via#le volume of activity

Most commentators argue that there is a finance gap for growth small #usinesses in relation to

long-term de#t, e"uity and flotation in a$istan. This has also #een found in other !estern

countries.

The small #usiness growth cycle did not include the development of the high-growth technology-

#ased SME which underta$es research and development, develops samples and commerciali+es

its innovations prior to Stage 1 %start-up&. Although such enterprises may #e a#le to reach Stage 1

#y using personal funds and government assistance, actual start-up and early growth re"uire

e"uity #eyond the owners resources.

Although there is evidence of a finance gap for the three aspects discussed, there is no consensus

regarding its causes. There can #e supply-side considerations due to gaps in the capital mar$et

for unlisted companies.

There are also demand-side issues for SMEs that wish to grow #ut are unwilling to accept

e(ternal long-term funds. Small #usiness literature provides theoretical and empirical support for

the pec$ing order approach #y small #usiness operators see$ing funds.

$ CAPITAL B/0GETING IN TE SME:


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#udgeting theory& against other o#)ectives such as maintaining the independence of the #usiness

when ma$ing investment decisions. Second, small firms lac$ the personnel resources of larger

firms, and therefore may not have the time or the e(pertise to analy+e pro)ects in the same depth

as larger firms. 'inally, some small firms face capital constraints, ma$ing pro)ect li"uidity a

prime concern. 6ecause of these small firm characteristics the capital #udgeting decisions of

large firms are not li$ely to descri#e the procedures used #y small firms.

To document the capital #udgeting practices in SME the results are ta$en from different surveys.

nformation a#out the types of investments the firm ma$es %e.g., replacement versus e(pansion&

the primary tools used to evaluate pro)ects %e.g., discounted cash flow analysis, pay#ac$ period&,

the firms use of other planning tools %e.g., cash flow pro)ections, capital #udgets, and ta(

planning activities&, and the owners willingness to finance pro)ects with de#t.

Dot surprisingly, we find small and large firms evaluate pro)ects differently. !hile large firms

tend to rely on the discounted cash flow calculations favored #y capital #udgeting theory

%Graham and Farvey, 2::1&, small firms most often cite 0gut feel and the pay#ac$ period as

their primary pro)ect evaluation tool. 3ess than 1 percent of the firms claim discounted cash

flow analysis as their primary criterion, and over /: percent of the firms do not estimate cash

flows at all when they ma$e investment decisions.

+.1 C&*i%&! Bu4'%in' T,($ &n4 S3&!! Fi(3s:6realey and Myers %2::/& present a simple rule managers can use to ma$e capital #udgeting

decisions7 nvest in all positive net present value pro)ects, and re)ect those with a negative net

present value. 6y following this rule, capital #udgeting theory says firms will ma$e the set of

investment decisions that will ma(imi+e shareholder wealth. And, #ecause net present value is a

complete measure of a pro)ects contri#ution to shareholder wealth, there is no need for the firm

to consider alternative capital #udgeting tools, such as pay#ac$ period or accounting rate of

return.

Het, small firms often operate in environments that do not satisfy the assumptions underlying the

#asic capital #udgeting model. And, small firms may not #e a#le to ma$e relia#le estimates of

future cash flows, as re"uired in discounted cash flow analysis.


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+.+ C&*i%&! Bu4'%in' Assu3*%i,ns &n4 % S3&!! &n4

34iu3 n%(*(iss:


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+./ P(,7#% E8&!u&%i,n M%,4s in SME:n this, responses a#out the primary tool firms use to assess a pro)ects financial via#ility7

pay#ac$ period, accounting rate of return, discounted cash flow analysis, 0gut feel, or

com#ination. The most common response is the least sophisticated, gut feel selected #y 2>

percent of the sample firms in a$istan.

+./.1Gu% "!:

The use of gut feel is strongly related to the #usiness owners educational #ac$ground. wners

without a college degree resort to it most fre"uently and owners with advanced degrees least.

The use of gut feel is also inversely related to a firms use of planning tools. 'irms with written

#usiness plans and firms that ma$e cash flow pro)ections are significantly less li$ely to rely on

gut feel.

!hile the use of gut feel is concentrated in the least sophisticated of small firms, it is also widely

used #y firms that ma$e primarily replacement investments. A firm may have limited options

when it replaces e"uipment, and estimating future cash flows %i.e., incremental maintenance

costs or efficiency gains& for each option might #e difficult. 'or e(ample, if a firm must replace a

delivery truc$, it may #e difficult for the firm to estimate differences in the future annual

operating costs of two replacement vehicles under consideration. Moreover, if an investment is

necessary for the firms survival %and the owner is committed to maintaining the #usiness as a

going concern&, the ma(imi+ation of firm value may not #e the #usiness owners primary

o#)ective. nstead, the owner may simply loo$ for the alternative promising the re"uired level of

performance at the most reasona#le cost. Thus, it is not surprising to find that small #usiness

owners use relatively unsophisticated methods of analysis to evaluate replacement options.

Gut feel is also used e(tensively #y firms in the service industry. Although some service firms

ma$e su#stantial capital e(penditures, the investments of many service firms might #e limited to

#usiness vehicles or office e"uipment. 6ecause a firms primary considerations when evaluating

this type of purchase decision may #e cost, relia#ility, and product features, structuring a

discounted cash flow analysis of these investments can #e difficult.


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+./.+P&$5 *(i,4:

The definition of pay#ac$ period for capital #udgeting purposes is simple. The pay#ac$ period is

the num#er of years it ta$es to pay#ac$ the initial investment of a capital pro)ect from the cash

flows that the pro)ect produces.

ay#ac$ period is the second most common response, selected #y 19 percent of the small

enterprises. The pay#ac$ period is used slightly more often #y firms that will wait for cash, as

e(pected. 'irms using the pay#ac$ period are significantly more li$ely than other firms to

estimate future cash flows %#ecause cash flow estimates are re"uired for this calculation&. 'inally,

use of the pay#ac$ period appears to increase with the formal education of the #usiness owner.

These results suggest that the pay#ac$ period conveys important economic information in at least

some circumstances. 'or e(ample, the pay#ac$ period can #e a rational pro)ect evaluation tool

for small firms facing capital constraints %i.e., firms that do not operate in the perfect financial

mar$ets envisioned #y capital #udgeting theory&. n this case, pro)ects that return cash "uic$ly

could #enefit a firm #y easing future cash flow constraints.

+././A##,un%in' (&% ," (%u(n:Accounting rate of return %also $nown as simple rate of return& is the ratio of estimated

accounting profit of a pro)ect to the average investment made in the pro)ect. A44 is used in

investment appraisal.

A44 JAverage Accounting rofit

Average nvestment

The accounting rate of return is the ne(t most fre"uent choice, identified #y 18 percent of thefirms as their primary evaluation method. The use of accounting rate of return increases with

firms growth ratesK it is significantly higher than the sample mean for firms entering new lines

of #usiness. Each of these characteristics can indicate high #orrowing needs. The accounting rate

of return is thus especially important if a firm must provide #an$s with periodic financial

statements, or is re"uired to comply with loan covenants #ased on financial statement ratios.


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+./.2Dis#,un%4 #&s 9,- &n&!$sis:


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+.2 Su33&($:'irms with fewer than 2: employees analy+e potential investments using much less

sophisticated methods than those recommended #y capital #udgeting theory. n particular, survey

results show these #usinesses use discounted cash flow analysis less fre"uently than gut feel,

pay#ac$ period, and accounting rate of return.

Many small-#usiness owners have limited formal education, and their firms may have

incomplete management teams. Therefore, a lac$ of financial sophistication is an important

reason why the capital #udgeting practices of small firms differ so dramatically from the

recommendations of theory. Small staff si+es also constrain the amount of capital #udgeting

analyses the firms can perform. 6eyond this, there are also su#stantive reasons a small firm

might choose to use methods other than discounted cash flow analysis to evaluate pro)ects.

The primary reason is that many small #usinesses do not operate in the perfect capital mar$ets

that capital #udgeting theory assumes. Most of the firms in our sample are very small %with

fewer than 1: employees&K they have short operating histories %almost half have #een in #usiness

under 1: years&, and their owners are not college educated. These characteristics may limit their

#an$ credit, posing credit constraints. f so, these firms may #e re"uired to finance some future

investments using internally generated funds, and it would not #e surprising for the owners to

consider measures of pro)ect li"uidity %such as the pay#ac$ period& when ma$ing investment

decisions.

Second, many of the investments that small firms ma$e cannot easily #e evaluated using the

discounted cash flow techni"ues recommended #y capital #udgeting theory.

Many investments #y small firms are not discretionary %a firm either ma$es a specific investment

or it goes out of #usiness&, and future cash flows can #e difficult to "uantify. 'or e(ample, if a

firm is introducing a new product line, estimates of future cash flows can #e imprecise %and

mar$et research studies re"uired to o#tain #etter cash flow estimates may not #e cost effective&.

!hen future cash flows cannot #e easily estimated, discounted cash flow analysis may not

provide a relia#le estimate of a pro)ects contri#ution to firm value, and it is not surprising that a

firm might resort to gut feel to analy+e the investment.


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'or these reasons, small firms face capital #udgeting challenges that differ from those faced #y

larger firms. Thus, it is possi#le that optimal capital #udgeting methods for large and small firms

may differ. Fowever, a fully integrated capital #udgeting theory identifying the conditions under

which discounted cash flow analysis is appropriate has yet to #e developed. The "uestion of how

to #etter tailor the prescriptions of capital #udgeting theory for small firms remains unanswered.

+. T I3*,(%&n# ," C&*i%&! Bu4'%in' in #u((n%

s#n&(i,:n the world of #usiness, capital #udgeting is one of the most important steps that a company can

ta$e. Many in the #usiness world do not properly understand the importance of capital #udgeting.

Fere are the #asics importance of capital #udgeting.

+..1D8!,* &n4 ",(3u!&% !,n'%(3 s%(&%'i# ',&!s:The a#ility to set long-term goals is essential to the growth and prosperity of any #usiness. The

a#ility to appraisevalue investment pro)ects via capital #udgeting creates a framewor$ for

#usinesses to plan out future long-term direction.

+..+S0 ,u% n- in8s%3n% *(,7#%s:

Inowing how to evaluate investment pro)ects gives a #usiness the model to see$ and evaluate

new pro)ects, an important function for all #usinesses as they see$ to compete and profit in their

industry.

+../Es%i3&% &n4 ",(#&s% "u%u( #&s 9,-s:

'uture cash flows are what create value for #usinesses overtime.


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6y definition a #udget carefully identifies the necessary e(penditures and 4NL re"uired for an

investment pro)ect. Since a good pro)ect can turn #ad if e(penditures arenOt carefully controlled

or monitored, this step is a crucial #enefit of the capital #udgeting process.

+..C(&%i,n ," D#isi,n:!hen a capital #udgeting process is in place, a company is then a#le to create a set of decision

rules that can categori+e which pro)ects are accepta#le and which pro)ects are unaccepta#le. The

result is a more efficiently run #usiness that is #etter e"uipped to "uic$ly ascertain whether or not

to proceed further with a pro)ect or shut it down early in the process, there#y saving a company

#oth time and money.

3 TE EFFECTS 9F CAPITAL B/0GETING TECNI/ES 9N

TE G;9


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/.2 L,n' %(3 E#% ,n P(,;%&5i!i%$:


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# ;EFE;ENCES:

http7www.investopedia.comuniversitycapital-#udgetingimportance.asp

https7www.researchgate.netpu#lication222>8:>/2PFowPlanningPandP/21

http7www.finwe#.comfinancial-planningthe-importance-of-capital-

#udgeting.htmlRa(++89fLhy:n

http7accountlearning.comneed-and-importance-of-capital-#udgeting-decisions
http://www.investopedia.com/university/capital-budgeting/importance.asphttps://www.researchgate.net/publication/222640632_How_Planning_and_Capital_Budgeting_Improve_SME_Performancehttps://www.researchgate.net/publication/222640632_How_Planning_and_Capital_Budgeting_Improve_SME_Performancehttps://www.questia.com/library/journal/1P3-2922990971/capital-budgeting-government-policies-and-the-performancehttps://www.questia.com/library/journal/1P3-2922990971/capital-budgeting-government-policies-and-the-performancehttp://www.financepractitioner.com/balance-sheets-best-practice/managing-capital-budgets-for-small-and-medium-sized-companies?page=1http://www.financepractitioner.com/balance-sheets-best-practice/managing-capital-budgets-for-small-and-medium-sized-companies?page=1http://www.questionpro.com/a/showSurveyLibrary.do?surveyID=363821http://www.finweb.com/financial-planning/the-importance-of-capital-budgeting.html#axzz49fDhy0Vnhttp://www.finweb.com/financial-planning/the-importance-of-capital-budgeting.html#axzz49fDhy0Vnhttp://accountlearning.com/need-and-importance-of-capital-budgeting-decisions/http://www.investopedia.com/university/capital-budgeting/importance.asphttps://www.researchgate.net/publication/222640632_How_Planning_and_Capital_Budgeting_Improve_SME_Performancehttps://www.researchgate.net/publication/222640632_How_Planning_and_Capital_Budgeting_Improve_SME_Performancehttps://www.questia.com/library/journal/1P3-2922990971/capital-budgeting-government-policies-and-the-performancehttps://www.questia.com/library/journal/1P3-2922990971/capital-budgeting-government-policies-and-the-performancehttp://www.financepractitioner.com/balance-sheets-best-practice/managing-capital-budgets-for-small-and-medium-sized-companies?page=1http://www.financepractitioner.com/balance-sheets-best-practice/managing-capital-budgets-for-small-and-medium-sized-companies?page=1http://www.questionpro.com/a/showSurveyLibrary.do?surveyID=363821http://www.finweb.com/financial-planning/the-importance-of-capital-budgeting.html#axzz49fDhy0Vnhttp://www.finweb.com/financial-planning/the-importance-of-capital-budgeting.html#axzz49fDhy0Vnhttp://accountlearning.com/need-and-importance-of-capital-budgeting-decisions/

Documents

Capital Budgeting Subhan