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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 24
BUDGETING PROCESS
The following topics will be discussed in this lecture.
Budgeting process
Purpose / functions of budgets
Cash budgets ­ Preparation & interpretation
The Budget Process
The Budget process allows the company to:
set its fiscal objectives in respect of revenue, expenditure, debt repayment and investment;
maintain an effective fiscal control and plan for the coming year and beyond;
allocate the available resources, consistent with the Company's strategic objectives and priorities;
fulfill the legislative requirements for the Budget; and
Seek authority from Parliament for spending.
All Managers have a key role in the budget process. Together, they agree on the budget strategy and
priorities for spending. On an individual level, Managers identify priorities for departmental chief
executives to guide preparation of Budget submissions.
Budget Preparation Process:
1. Budget Policy & Details ­ Communicating To All
This includes disseminating details like the budgeting period, time table and formation of budgeting
committee.
The main objective is to make clear of the scope and roles of people involved in this process. Normally,
budgeting period is a period of 12 months. It may be calendar year or any combination of 12 months.
However, it is always broken down into 12 periods of one month or into quarters because of comparison
with actual performance and control purposes.
This process is formalized by forming a committee comprising of different front line managers and a very
senior person is appointed to head this committee. Such a person should have a clear vision of future and
unambiguous understanding of corporate objectives. Budgets are used to translate the ultimate objectives
into monetary terms as a course of action to accomplishment of those objectives.
A budget has to be finalized before the start of the period for which it is being prepared. For example,
budget for 2006 must be completed before January 2006. The time to complete budget will vary firm to
firm, on the type of budget and the budget period. There are different phases in budget preparations and
timeliness is set for each phase.
2. Determining The Limiting Factor
Budget preparation normally begins with the identification of limiting factor. This refers to a factor that
limits the stretch of company or hinders company's achievement of specific objective. The first step will be
to determine the sales during the budget period. The first question will be "do we have the capacity to
produce this much?" Assuming that the answer is "no" then, production capacity is the limiting factor. You
can't achieve what you have determined and need to cut-down your plans or revise your target sales.
The other areas may be the availability of labor force and/or raw materials. If there's no limiting factor then
company can start with the target sales and if there's one that hampers target, then it would be what can be
achieved with the available resources.
3. Production Budget Preparation
The primary source of inflow comes from the principal activity or sale of goods. Therefore, in budget
preparation sales is the kick off point.
Sales budget is prepared in quantitative form. Each product sales is mentioned in number of units to be
produced. There is a standard specification of a unit in terms of the input material requirements; labor time
and amount of overhead needed to manufacture it. There's also a standard selling price of each product
unit.
Sales in monetary term are calculated by multiplying number of units to be produced by standard selling
price.
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Corporate Finance ­FIN 622
VU
Next step will be to determine the expense side of number of units to be produced in the budget period.
This is known as production cost budget and is divided into three categories.
First step will be to determine the total raw material requirements by multiplying the number of units to be
produced by standard quantities of input materials. The dollar value of direct material cost is calculated by
multiplying derived quantities by the standard purchase price.
In second step, direct material requirements are worked out. Standard time to produce one unit is multiplied
with number of units to be produced. The total production hours are multiplied by standard labor rate per
hour to reach at total labor cost.
The third segment in cost of sales determination is to estimate the overhead to be absorbed per unit of
output. This is normally done by dividing the estimated amount of overheads by the activity level ­ labor
hours.
Adding these three segments ­ direct materials, direct labor and overhead render total cost of production.
4. Other Ancillary Policy Issues Determination
The other items that are determined in this phase includes but not limited to the minimum level of finished
goods level, purchases of each raw materials and raw material ending inventory levels.
5. Functional Budgets & Negotiation
After the sales and production cost budget has been determined then comes the step where individual
departments or functional budgets are prepared. Every functional manager is required to prepared and
present before the budget committee budget for the forthcoming period.
6. Adjustments & Trimming
Once the sales, production cost and functional budgets have been submitted to the committee then there
are discussions and negotiations and adjustments are made in the light of available resources and short term
objective of the firm. If there is shortage of resources then departmental budgets are trim down. At the
point where the trade off between resources and resource utilization is achieved, it is deemed as final.
7. Finalization Of Budget & Implementation
Final version of budget is presented to head of committee who then present it to chief executive officer. If
CEO has some reservations it may ask for reconsideration or can approve as is. After CEO ratification the
budget is approved for implementation.
8. Variance Analysis & Investigation
After the budget is approved and implemented, the actual performance is compared with the budgeted one
and variances are calculated. Variance is the difference between the actual and budgeted numbers. The
variance is investigated as to know the root cause of difference. The information is used to adjust the next
budgets period.
Specific Phases of the Budget
The Budget process can be divided into distinct phases:
Common Purposes/Functions behind Budget Activity
Planning -- involves determining organizational and program objectives and evaluating alternative means
for their achievement. Planning also includes prioritizing.
Control -- defined as monitoring, comparing information to a standard and taking corrective action. For a
budget to serve this function well it must have four characteristics:
It must be well-conceived (i.e., result from a good planning process) and be approved by the board
It must be broken down into increments corresponding to the periodic financial statements
Financial statements must be prepared on a timely basis and compared to the budget
The board and staff must take action where such comparison indicates a potential problem.
Management -- allocating resources deliberately and prudently to achieve program objectives.
This includes programming approved goals into specific projects and activities, the design of organizational
units to carry out programs, staffing, and procurement of resources.
Cash Budgets
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Corporate Finance ­FIN 622
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An Introduction to Preparing Cash Budgets
When many people first have to prepare a cash budget or a cash flow statement they start out thinking that
they're easy to do. Half way through, though, a mist seems to settle over their eyes and they become
impossible to do.
The problem usually comes down to matters such as the layout, the balances brought down and carried
down and the debtors and creditors.
Most things to do with the cash itself are simple to account for: the day we receive the cash, we put it into
the statement; the day we pay some cash, we put that in the statement ... that's pretty well all there is to do
with the cash itself.
OK, so the cash itself is simple to deal with but there is still a lot more to be worried about I can hear you
screech! Fear not, though, help is at hand on this very page.
We'll start by taking a look at the layout and contents of cash budget overall. Then we'll have a look at an
alternative layout, remembering that whatever the layout, they should all give the same answer! Finally, we'll
spend some time solving all of your debtor and creditor worries!
Overall Layout of a Cash Budget
Here we have a cash budget statement that starts with the cash balance brought down (b/d) from last
month, last week or yesterday (this is the cash we had in the safe or our purse or wallet at the end of the
previous period). Then we add the cash receipts to the balance b/d to give us the total amount of cash we
then have available to us: this is the amount of money we can spend.
However, we usually have bills to pay, so we take away from the cash available the amount of money we
have to pay for our bills, utilities, materials, labor and so on. Starting with the balance b/d adding the
receipts and taking away the payments leaves us with the balance carried down (C/D); and this is what we
have left at the end of the month ready for use at the start of the following month.
Alternative Layout of a Cash Budget
In addition to dealing with debtors and creditors, which we will deal with shortly, there is the key issue of
alternative layouts. Here we see an alternative layout that has exactly the same information in as the
previous example but they are presented in a different order.
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Corporate Finance ­FIN 622
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Most importantly, though, the balances C/D at the end of each month are the same whichever layout we
use. Just compare this new layout and the balances C/D with the previous layout we saw above.
Cash Flow Statement
This statement is governed by international accounting standard # 7
·  Purpose of cash flow statement is to provide information about the inflows and outflows of cash
and cash equivalents. The inflows and outflows are grouped into three categories.
·  Cash & cash equivalents are short term, highly liquid investments that are both readily convertible
to cash and without loss of value.
·  Statement is divided into three categories
­  operating activities
­  investing activities
­  financing activities
·  Purpose of cash flow statement
·  To identify and assess the ability to generate future net cash flow from operations to pay debt,
interest and dividends
·  External financing requirements
·  To see the effects of cash & non cash investing and financing transactions.
·  Assess the reasons for differences between income and associated cash receipts and payments
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk