Module 4- Public Corporate Finance

For Classroom Purposes Only

Budgeting, Its Objectives and Budgetary Control

Budgeting is the process of translating a plan in quantitative terms, usually

monetary. Once the major undertakings of an enterprise have been programmed, they
are restated in quantitative terms in a formal statement called the budget.

Objectives of Budgeting:

1. Planning- The financial plan of the different sub-units are prepared geared
towards the attainment of the company’s predetermined objectives. These
include the profit plan, budgeted balance sheets, capital expenditures budget,
and the cash budget so that expected results of operations and their effects on
financial resources can be visualized.
2. Coordination- Budgeting brings about harmony and synchronized operations for
the different levels of management. Heads of the different sub-units of an
organization are made aware of their common goal and their contributions to the
attainment of company objectives.
3. Control- Budgeting provides management with the yardstick in evaluating
performance. Periodic comparison between actual and budget figures is done to
ensure that operations are in accordance with plans and therefore geared
towards predetermined objectives. Variances are analyzed and the possible
causes are determined to minimize if not totally avoid them for the rest of the
year.
4. Budgetary Control- Refers to the use of budgets and budgetary reports to
coordinate, evaluate and control day-to-day operations to attain the goals
specified by the budget.

The Budgeting Process

Top management formulates its overall objectives, plans, and policies and assumptions
to serve as guidelines in the preparation of the budget estimates.

The preparation of budget estimates starts with sales forecasting. Sales forecasts are
considered the cornerstone in budgeting.

The heads of the different responsibility centers, in consultation with their immediate
superiors, prepare their individual budgets based on planned volume of activities.

The individual budgets are then consolidated into a tentative master budget which may
undergo revisions until an acceptable one is produced.
Finally, top management approves the final master budget and disseminates the
approved budget to the different responsibility centers.

Master Budget

The consolidation of all the budgets of the different sub-units (departments,

branches, and sections ) in an enterprise is called the master budget. It serves as the
management’s principal vehicle for coordinating the plans of the firm.

It consists the following:

1. Operating budget or profit plan- This refers to the plan of operations wherein details
of revenues and expenses are shown and takes the form of budgeted income
statement.
2. Financial resources budgets- These show the effects of the profit plan on the
financial resources of the company and consist of the budgeted balance sheet and
cash budget.
3. Capital expenditures budget- This is in the form of a statement showing the planned
procurement, and disposal of plant, property and equipment.

CAPITAL BUDGETING

Management is originally hired to take control of the funds of the owners of the
business. In most cases, it involves the maximization of the earning power of these
funds. The planning and control of capital expenditures is, therefore a basic executive
function. As such, the budgeting of funds for capital expenditures is a very important
activity of management.

Basic Terms in Capital Budgeting

Capital Expenditures – It refers to substantial outlay of funds, the purpose of which is

to lower costs and increase net income for several years in the future. It includes
expenditures that tie up capital inflexibility for long periods. It covers not only outlays for
fixed assets but also expenditures for major research on new products and methods
and for advertising that has cumulative effects.
Classes of Capital Expenditures

1. Replacement investments- this refers to investments on replacement of worn-out

or obsolete facilities;
2. Expansion investments- this type of expenditure will provide additional facilities to
increase the production and/or distribution capabilities of the firm;
3. Product-line or new market investments- this refers to expenditures on new
products or new markets, and on improvement of old products with the combined
features of replacement and expansion investments.
4. Investments in safety/or environmental projects- these are expenditures
necessary to comply with government orders, labor agreements, or insurance
policy terms. These are sometimes called mandatory investments or non-
revenue producing projects.
5. Strategic investments- these are investments designed to accomplish the overall
objectives of the firm.
6. Other investments- this catch-all term include office buildings, parking lots, and
executive aircraft.

Capital Budgeting – the planning and control of capital expenditures. This activity is
essential because it provides a systematic evaluation of the firm’s alternatives. It helps
management in choosing an alternative that will provide the best yield for the company.

Valuation- The process of determining the proposal’s real worth to the firm.

Investment- It is made when a firm spends some of its funds for the establishment of a
project. By doing so, the opportunity to use the same funds in other possible projects is
lost.

2 Forms of Investment

1. Initial Investment- it refers to the amount that has been devoted to a project until
it generates cash inflows from operations.
2. Later Investment- expenditures made after the first cash inflow

OBJECTIVES OF CAPITAL BUDGETING

1. Establishing Priorities;
2. Cash Planning
3. Construction Planning
4. Eliminating Duplication
5. Revising Plans
CAPITAL BUDGETING SYSTEM

The capital budgeting system is composed of the following:

1. Preparation and submission of budget requests;

2. Approval of budget;
3. Request of appropriation;
4. Submission of progress report; and,
5. Post approval reviews.

BUDGET REQUESTS

Budget Requests are those made to include in the corporate budget capital
projects which are felt to be desirable by those in the lower organizational levels.

The budget request contains the following:

1. Project Title:
2. Cost, including estimates on:
a. Fixed Capital
b. Working Capital
c. Non-operating Outlays
d. Other, including opportunity cost;
3. Priority Rating of the Project;
4. Profitability of the Project;
5. Timing or the ability to adhere to a construction schedules;
6. Financing Methods;
7. Project Classification; and,
8. Project Narrative.

APPROVAL OF THE BUDGET

The Approval of the Budget is a process which requires the following steps:

1. Budget requests are forwarded to the top management;

2. Top management decides which projects to recommend to the board
of directors;
3. Top management sends recommendation to the Board of Directors;
4. The Board of Directors approves or disapproves the recommendations;
and
 5. Top management informs projects sponsors of the action taken on
their projects.

REQUEST FOR APPROPRIATION

After the approval of the budget, the next step undertaken is getting an
appropriations request approved. The officers and managers of the corporations are
usually given the authority to approve appropriations requests up to certain established
limits.

The appropriations request usually contains the following:

1. The request and the authority section- this serves to identify the originator
and the project:
2. The narrative section- this details the requesting entity’s justification for
undertaking the proposal. This section normally includes the following:
a. Proposal;
b. Objectives;
c. Conceptual Framework;
d. Alternatives; and
e. Sensitivity and Risk.
3. Supporting Documentation Section- This contains cost estimates and the
results of market studies and financial analysis.

SUBMISSION OF PROGRESS RESPORTS

Progress Reports are submitted at regular intervals for the following purposes:

1. To review the accuracy of the expenditures forecasts;

2. To provide updated expenditures forecasts; and
3. To verify the assumptions and economics underlying the acceptance of the
individual projects.

POST APPROVAL REVIEWS

Post approval reviews are required to satisfy the following objectives:

1. To provide management with a standard method of evaluating the abilities

and judgment of projects sponsors;
 2. To identify errors or patterns of error in judgment which can be avoided in
future similar situations; and
3. To help ensure that the quality and accuracy of information attains the highest
feasible standards.

EVALUATION OF PROPOSED CAPITAL EXPENDITURES

Proposed capital expenditures should be scrutinized since they involve large

outlays of funds. A number of primary factors should be considered by management.

These are the following:

1. Urgency. Decisions should be made as quickly as possible for requirements that

are urgent.
2. Repairs. Management should consider the ability of spare parts and maintenance
experts. When these are critical and they are not available, the concerned
proposal should be ruled out.
3. Credit. This factor should be considered in the sense that some credit terms may
be highly favorable to the company.
4. Non-economic Factors. These refer to social considerations, and other non-
economic persuasions and preferences.
5. Investment Worth. This refers to the economic valuation of a certain proposal.
6. Risk involved. This refers to the uncertainty of an expected return.