Zero-based budgeting (ZBB) is a method of budgeting, wherein the process of planning and preparing the budget starts from zero, instead of previous budgets as in the case of traditional budgeting.
Capital budgeting is typically defined as the process used by companies for decision making on capital projects with a life of a year or more. The process takes centre stage in corporate finance as capital projects make up the long-term assets portion of the balance sheet. Sometimes, capital projects for a company could be so large that a sound capital budgeting process could ultimately decide the future, and capital decisions cannot be easily reversed at low cost, so committing a mistake could be proven very costly. The principles of capital budgeting have been adapted for many corporate decisions, including working capital management, leasing, mergers & acquisitions (or M&A), bond refunding, and investment decisions. Moreover, the valuation techniques or principles used in capital budgeting are tantamount to valuation principles used in security analysis and portfolio management and mainly focus on increasing the shareholders’ wealth. The Process of Capital Budgeting The primary stage of the capital budgeting process is to generate investment ideas, which could practically come from any level within an organisation, and it makes it the very first and the most important process or step of capital budgeting. Step two or the second process in typical capital budgeting is to analyse those investment ideas via gathering information to forecast the future cash flows for each investment idea and then evaluating their profitability. The tertiary step or the third process of capital budgeting is to plan the capital budget via fitting the profitable investment idea into the overall business strategy. The last but one of the most important steps of capital budgeting is monitoring and post-auditing once the idea generated has been successfully completed into a capital project. Types of Capital Budget Projects Replacement Projects Replacement projects are one of the easiest capital budgeting decisions, which generally deals with the replacement of worn-out machinery, projects, inventory, and so on. In replacement projects, if the expenditure is modest and the equipment has significant implications, the finance department or capital budget analysts typically ignore overanalysing the project. Expansion Projects Expansion projects are those projects which increase the size of the business instead of maintaining the existing business of the company like replacement projects. New Products and Services These types of investment projects bring more uncertainty than expansion projects and are mainly for increasing customer experience or tapping a new market. Regulatory, Safety, and Environmental Projects These are types of projects frequently required by government or local authorities. Such types of projects generate no revenue and are generally in place to benefit local communities, government, or society. However, such projects could be very costly for companies at times, and decision around such projects could be very crucial. Underlying Principle of Capital Budgeting Capital budgeting mainly relies on just a few principles and use some assumptions. Decisions are based on cash flows. In capital budgeting decisions are purely based on cash flows of an individual or a group of projects, and they do not consider the accounting concepts such as net income, EBIDTA, and so on. Also, this assumption or principle ignores intangible costs and benefits. Timing of the cash flow is of paramount importance. Cash flows are based on opportunity costs, i.e., the opportunity foregone in the next best alternative. Cash flows are analysed on an post-tax basis. Financing costs are ignored. This assumption or the principle may seem unrealistic, but all capital budgeting methods plainly assume that the required rate of return or the discount rate used to reach capital budgeting decision, considers the financial cost. Thus, incorporating the finance cost twice could lead to unnecessary complications. Investment Decision Criteria Under Capital Budgeting There are several methods for reaching an investment decision in capital budgeting, including Net Present Value (or NPV), Internal rate of return (or IRR), payback period, discounted payback period, average accounting rate of return, and profitability index (or PI). However, the most prominent is only the NPV and IRR. Net Present Value (or NPV) Net present value (or NPV) is ideally defined as the sum of all discounted cash inflows for a project netted against the initial cash outflow or initial outlay. The investment decision with NPV is relatively simple, i.e., investment if NPV > 0, and do not investment if the NPV < 0. Internal Rate of Return (or IRR) Internal rate of return (or IRR) is defined as the discount rate, which makes the present value of all projected cash inflows equal to the initial cash outflow. The investment decision with IRR is; Invest if IRR > required rate of return Do not invest if IRR > required rate of return Payback Period The payback period is defined as the number of periods required to cover the initial outlay of cash into a project. Suppose a project calls for an initial cash outflow of $10,000 with cash inflows of five annual equal cash inflows of $2,000. The payback period for the investment would be 5 years. While this investment decision contains many drawbacks, the payback period gives an idea about the liquidity of a project. Discounted Payback Period The discounted payback period is almost similar to the payback period; however, it uses the discount rate to find the time required to cover the initial outlay by calculating the PV of the cash inflows. Thus, the discounted payback period could be defined as the number of periods it takes for the cumulative discounted cash flow to become equal to the initial outlay. Average Accounting Rate of Return (or AAR) The average accounting rate of return could be defined as However, AAR is seldom used in capital budgeting as unlike other methods, it considers accounting numbers for calculation and ignores the cash flows. Profitability Index The profitability index could be defined as the present value of all future cash inflows divided by the initial outlay. The above equation could also be rearranged as below: The decision criteria form PI under capital budgeting is as below: Invest if PI > 1.0 Do not invest, if PI < 0
Capital Expenditure (CapEx) What is Capital Expenditure? Popularly called as CapEx, it means the expenditure incurred by an entity in maintaining, upgrading or purchasing non-current assets. Capital Expenditure is the amount spent by an entity on fixed assets with the usage of over one year and intangible assets. Private Capital Expenditure is often used as a proxy for non-public investments. A higher level of CapEx may indicate that investment is higher, and the reverse is true. Therefore, CapEx by corporates serves as a proxy for private investments to some extent. In accounting terms, it hits cash flows from investing activities along with movement in value or scale of assets. In the next year, the company will charge Depreciation and Amortisation on the asset, which will hit Income Statement. Investment into intangible assets is also considered capital expenditure as patents, rights, trademarks, Knowhow, technology would provide benefits to the business over the years. Fixed assets investments of businesses include the purchase of machinery, upgrade to machinery, incorporating a new plant. Moreover, CapEx being an expenditure is added to assets of business since it would deliver benefits over the future. Revenue Expenditure vs CapEx Revenue Expenditure of a company includes its operational expenses where the benefits to business from such expenditure would be short-term. It would include marketing expenses, distribution expense, employee costs etc. These expenditures are not capitalized and thus are booked in the profit and loss account. Whereas CapEx by a company would deliver the benefits to the business for more than one year and allow the business to grow sustainably over the future. CapEx is often planned and budgeted for years and includes a higher level of evaluation by the management. The management often segregate the capex as growth or maintenance capex. More on this: Growth Capex Vs Maintenance Capex – Aping the Convention or an evolving distinction? Types of Capital Expenditures Asset purchases: It means when an enterprise buys asset to benefit the business over the long run. A purchase of a new building would enable the business to increase its scale of products, and the new machinery installed in the building would manufacture products or aid in the manufacturing of products until the useful life of the asset. Do Read: Restaurant Brands New Zealand to Purchase KFC Stores Asset improvements: It may include any upgradation to the existing asset base of the company, including a new software or technology, the addition of new part to improve output from existing assets, or maintenance of the assets held by the business. Intangible assets: Expense incurred by a business in developing or acquiring intangible assets, like patents or trademarks, are also capital expenditure since the expected value from the assets would be realised over the long-term. DO Read: TNG Limited To Trademark Its Titanium Dioxide Pigment As TNG360 Why is CapEx important in investing? Investment is necessary to grow a business, and capital expenditures often set the path for growth in businesses. Management seeks to deliver the best out of its resources, which may require further enhancements to fulfil the vision of the business. CapEx seeks to derive further value for an enterprise through enhancements of existing assets, acquisition of new assets, adoption of new technology etc. It is an important decision that management of business seeks to take continuously and efficiently. CapEx by companies depends on various factors, including business model, products, industry, size, scale. For instance, a large scale mining company like BHP Group Limited (ASX:BHP) requires a much higher level of CapEx compared to an online retailer like Kogan.com Limited (ASX:KGN). But the expectations remain similar: to have a long-term sustainable revenue stream, enhancements to business models, or improvement in the profitability and sustainability of the business. Investors monitor capital decisions of firms very closely to ascertain short-term as well as long-term implications. Since Capital Expenditure often includes large sums of money, it becomes imperative for investors to evaluate CapEx decisions of firms, sources of funds employed in CapEx, or expected liquidity of the business over the near-term. Moreover, investors seek to test the capital budgeting by the management. However, there can be failures as well when the management expectations are not delivered by the past CapEx decisions. When things don’t turn as expected, it is likely that blame would be on management, but they would be appreciated when things turn out better than expected. It is the reason why investors devote a decent time to study the management style of the Board. Management takes the ultimate call for Capital Expenditure plans of a business, and they must evaluate the investment through a sound cost-benefit approach. The source of funds for the Capital Expenditure should also complement the long-term sustainability of the business. Companies fund their Capital Expenditure plans through debt or equity, and management must consider the appropriate source of funds to deliver expected benefits. Click here, to know about Afterpay Limited (ASX:APT) capital raising plans. Capital intensity and rise of Capital light business models Capital intensity of a business depends on the type of business. Large businesses that require heavy assets or regular enhancements would have large Capital Expenditure plans and need for capital, but a software company with a similar scale of revenues may not need huge Capital Expenditure. Capital intensive businesses come with long-term, a higher level of CapEx, and it is crucial for such business to manage CapEx plans. Companies engaged in Mining, construction business, equipment manufacturing, automobiles, energy, transports are considered as capital intensive business. Capital light business models have grown popular over time due to high margins and profitability. Such business models are expected to deliver relatively higher levels of free cash flows to the company over time. In asset-light businesses, the intensity of operational expenses or Revenue Expenditure is higher compared to CapEx. E-commerce companies like Amazon.com, Kogan.com Limited (ASX:KGN), Temple & Webster Group (ASX:TPW) are Capital light businesses. More on Information Technology Companies Capex: Why Capital Raising Is Sometimes Important For IT Stocks?
Have you ever thought about becoming financially independent or creating a decent wealth or maybe making your life worry-free from a financial standpoint? If the answer to any of these is Yes, then you probably need to focus on this vast subject of personal finance. So, what exactly is personal finance and how it may help you to achieve your financial goals? Personal finance is a very vast yet quite simple subject which covers everything that affects the financial health of an individual. It guides an individual on how to save money, the importance of an emergency fund, how and where to invest, how to achieve your retirement corpus etc. Below we will be touching upon a few of the essential aspects of personal finance that are a no-brainer to increasing your financial stability. Is savings the foundation of your financial stability? Savings to your financial goals is what food is to your body. Without the habit of savings, it isn't easy to achieve financial goals. Without the fundamental habit of saving, any level of income would be spent recklessly, and initial corpus to grow would get hammered constantly. One thumb rule of savings is “Pay yourself first” which has been described in Robert Kiyosaki’s book ‘Rich Dad Poor Dad’. This rule states whatever you are earning be it $1 or $1 million, always save a specific amount first and then look for spending the remaining income, instead of doing the opposite. In other words, spend what’s left after saving instead of saving what’s left after spending. Are multiple sources of income really helpful? Most people are having a single source of income, i.e. their salary to rely upon. But what if you could have two or more sources of income? Wouldn’t you be able to save at a higher rate or maybe achieve your goals well before projected time? This is the purpose of different sources of income, and in today’s world of internet, it’s not that difficult to create another source. Like if you are a good writer, you can write and self-publish your e-book or even start a blog. Love travelling? Start a vlogging channel on YouTube. Have any specialized skill? You can leverage it to others on freelancing sites. Perhaps, you can invest in equity, bonds, currency, commodity, derivatives or other different forms of assets. Judicious portfolio investment calls for sound qualitative and quantitative analysis. Emergency fund – Your umbrella on a rainy day? Life is uncertain and is full of both good times and bad times, but it is often the bad times for which we need to be prepared. Same goes for the financial stability of any individual which can take a hit at any point of time. To safeguard yourself for any uncertainty in the future, the creation of an emergency fund is mandatory. An emergency fund is also your savings which is kept isolated from the day-to-day reach so that by any means it cannot be dipped into for your normal expenditure. The sole purpose of this form of savings is to get a backup in the time of absolute need which is unforeseen like hospital bill for an accident or to keep you afloat for a few months in case the only source of income goes for a toss. Ideally, a person should have around 3 to 6 months’ worth of living expenses in his/her emergency fund. Does a budget provide enough worth as compared to the effort to create one? Most people are not into budgeting mainly because of the amount of efforts to constantly track the expenses, need for making a plan to tackle those and updating it with respect to changes in either income or expenses. Is it worth it after all of these constant efforts? To answer it in one line “What cannot be measured, cannot be improved”. If you are unaware of where your money is going, how much could be saved, what is the essential spending, then it is really difficult to optimize your expenses. Is Compounding the real gamechanger? Compounding, in its basic essence, is getting a return on an asset and reinvesting that return with the initial investment to generate an additional return. This way, the returns gradually becomes exponentially higher than any linear method. For example, If you invest $100 for a 10% compounded return, in the first year your return would be $10, but in the second year with the same 10% return, you would be getting $11 as your initial capital has also increased. But the real benefit of compounding is seen after a few years. To continue with the example above, look at the table below to get the real essence of compounding. As can be seen from the above table, after 10 years, the initial capital has grown more than 2.5 times with just 10% return per annum. This exponential growth is projected graphically on the chart below. Now comes the most asked question on how and where to invest? Is investing for a decent compounded return within the competence of an average individual having no expertise in this domain? First of all, investment is not rocket science; anyone with the basic understanding of the business and finance can invest on his own with proper due diligence. Mix of quantitative and qualitative analysis in the attractive assets, keeping in mind risk appetite and return expectations seem to be the key to successful investing. Apart from that, nowadays, a lot of financial/investment advisors are available who are better equipped with the knowledge and experience to do the job for you. A mutual fund is another example of outsourcing your investment-related work to a fund manager. Mutual funds are a pool of investment coming from retail investors which is invested in different assets. All the decision making is done by a dedicated fund manager on where to invest, how much to keep in cash etc. To sum it all up, always make sure that your income is always greater than your expenses and whatever means help you to achieve this basic principle, comes under the domain of personal finance.
Performance budgeting refers to the proces of developing budgets based on the relationship between a program's funding levels and expected results from that program. In an organisation, performance-based budgeting helps in managing costs based on the evaluation of the productivity of the different operations.