Capital Planning and Budgeting

Nur Aini Masruroh

http://aini.staff.ugm.ac.id/ ; Email: aini@ugm.ac.id; n_masruroh@yahoo.com

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

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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

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miCxc

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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

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,...,11

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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

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Capital rationing (cont’d) Can be formulated as transportation problem

jandiallforx

miax

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m

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