Friday, March 9, 2012

Financial Analysis of Capital and Operating Expenditures

Finance function of a firm manages the activity of raising money either through borrowing (short term or long term) or through equity capital and investment of excess money resources in financial assets. 

Finance managers of a company have the knowledge of information requirements of the financial markets as well as the current return expectations of the market and they in turn analyze the capital and operating expenditure plans of the firm and prepare the information for submission to the financial market participants.


Finance means money resources of the firm. Money is required to buy assets or pay off liabilities. Money in the form of cash or current/checking account deposits in banks does not yield any return. Hence a firm cannot have excess or idle money resources. It needs to invest excess money resources in return earning assets. If the money resources of a firm are insufficient, it can tap the credit market or equity market to mobilize additional money resources. Finance function of a firm manages the activity of raising money either through borrowing (short term or long term) or through equity capital and investment of excess money resources in financial assets. 

We can say, finance managers participate in the financial market on behalf of the firm. In the financial market, there are lenders and borrowers, and investors (buyers of financial assets) and business firms (sellers of financial assets). Financial market participants, individuals or institutions, lenders or equity investors provide money resources only to companies which have profitable operating activities and projects. In the special cases where they have to finance a firm with an expected loss in operating activities, they look for solvency and liquidity that assures them the return on their money with the promised interest/yield. To ensure this, financial market participants demand operating plans and capital expenditure plans from business firms and do a financial analysis. The financial analysis may extend to operating analysis if the resources to be committed are significant.

Finance managers of a company have the knowledge of information requirements of the financial markets as well as the current return expectations of the market and they in turn analyze the capital and operating expenditure plans of the firm and prepare the information for submission to the financial market participants. To make it more concrete, in India companies have to submit their annual budget to the banks for getting working capital loans. The finance manager has the responsibility of ensuring that there is an operating budget for the company and it is submitted to banks in the format specified by them. Similarly for capital expenditures, they have to ensure that the feasibility report is prepared in a standard format and acceptable return on capital is provided by the project before approaching the financial market for additional funds for the market.

The finance manager has the similar responsibility to the existing shareholders. He has to ensure that every expenditure is incurred to derive an acceptable return on capital. The goal of the finance management is defined as maximizing the value of shares or in the case of listed companies, the share price.

Financial Analysis of Capital Expenditure Proposals - Capital Budgeting

Capital budgeting or analysis of capital expenditure proposals may be divided into six steps.

1. Identification of potential investment opportunities and their economic analysis (Operating departments do it).
2. Assembling of proposed investments (At the finance department)
3. Financial analysis
4. Preparation of capital budget and appropriations
5. Implementation
6. Performance review.
Investment proposals are usually classified into categories for analysis

1. Replacement decisions
2. Expansion investments
3. New Product investments
4. Compliance/regulatory investments
5. Welfare investments
6. Research and Development projects
Capital expenditure analysis is based on cash flows. Every capital project involves net cash outflows for a year from some period of years and then net cash inflows for year for a number of years. In some projects, there can be net cash outflows in the terminal phase of the project, if there is cleaning up the site for hazardous wastes etc.
Cash flows of a project have to be estimated for a time horizon. The time horizon is the minimum of physical life of the plant, technological life of the plant, or the product market life.
In estimating the cash flows of a project, incremental principles (that considers all incidental effects), separation of investment and financing principle, post-tax principle and consistency principles are employed.
Incremental principle
In an existing company, the cash flows are to be estimated by evaluating the cash flows of the company with the project and without the project. The difference will be incremental cash flows related to the project.
Separation of investment and financing principle
In a standard capital expenditure analysis, interest payment to be made on borrowings is not brought into the picture. Borrowing is considered a financing decision and its impact is included in the cost of capital estimation. Hence cash flow estimates do not have any interest payment of component.
Post-tax principle
Tax impact on the cash flow is considered and after tax cash flows are estimated.
Consistency principle
The inflation expectation built into estimation of revenues and costs and cost of capital have to be consistent or same.
The finance department is assisted by the accounting department in its activities. They have the past history of various projects and proposals. They can estimate or make judgments on the biases of the persons who propose projects. So they go through the cash flow estimates provided by project sponsors to identify the biases and modify the estimates as needed.
Investment Criteria
A wide range of summary investment criteria have been used and all of them are discussed in finance books. Summary measures are criteria compress the information in multi-year cash flows or cash pattern into single numbers that can be used to take decisions.
The criteria are categorized into major categories with further subclassification.
I. Discounting Methods (criteria)
            1. Net Present Value (NPV)
            2. Internal Rate of Return (IRR)
            3. Benefit Cost Ratio
II. Non-discounting Methods (criteria)
1.      Pay back period
2.      Accounting Rate of Return (ARR)
1. Net Present Value (NPV)
It is the present value of all the net cash flows of a project. Present value of a net cash flow of a year is found by discounting the cash flow with the cost of capital.
2. Internal Rate of Return (IRR)
In internal rate of return calculation, the concept of net present value is used but with a difference. To determine IRR present value of cash inflows is equated to the present value of cash outflows with cost of capital taken as the unknown variable. When this equation is solved, you get a rate of return at which NPV is equal to zero. This rate of return as which NPV of the project becomes zero is called IRR.
IRR is then compared with cost of capital by the finance department. For example, a general policy is given to the departments that projects having IRR above 15% can be submitted for capital budget of the organization.  A department may submit a project with 15.5% IRR. If the cost of capital at that point in time is 17%, then financial analysis will not approve this project. Cost of capital keeps changing depending on the interest rates and risk premium in financial markets.
3.  Benefit Cost Ratio
Benefit cost ratio is the ratio between present value of cash inflows and present value of cash outflows.
4. Payback Period
It is a simple measure. It is the length of the time required to recover the initial cash outlay on the project through net cash inflows.
Example: Let us assume the project has an initial cash outlay of Rs. 25 lakh. The net cash inflows at the end of each during the first five years be: Rs. 5 lakh, 7 lakh, 13 lakh, 15 lakh and 16 lakh respectively.
In first three years, the project will give back cash inflow of Rs. 25 lakh which is the initial investment. Hence for this project, payback period is 3 years.
5. Accounting Rate of Return
In this method, profits are projected by the project accounting statements method instead of cash flows. The average of profit after tax say for first fives years is divided by the average book value of fixed assets (five years) committed to the project. This is not a rigorous measure.
Findings of a Recent Survey on Capital Expenditure Analysis
  1. Overtime, discounting methods have gained importance.
  2. Firms use multiple methods
  3. Accounting rate of return and pay back period are still used by many.
  4. Risk assessment of the projects is done and cost of capital is adjusted for risk. Risk assessment is done by sensitivity analysis.

Some Financial Analysis Systems in Use 

Office of Financial Analysis - University of Michigan
Budgeting Approach
Each cost center in Business and Finance has submitted documentation defining the services provided and resources required. (Each unit is responsible for maintaining the accuracy of this document over time.) Every unit is encouraged to take a long-term strategic approach to providing its services. This approach entails an annual review of the costs that must be incurred to provide valued services (regardless of past practices) at the most efficient (and understandable) cost. Once this level of service and funding is established, increments to the baseline are considered. Ideally this would involve the following approach:
    • Defining the current and future level of services provided, the resources necessary to provide those services and rationale for major change.
    • Evaluate current operations and identify issues and the gaps to providing future levels of service.
    • Look internally for cost saving measures or the elimination of services that are no longer required. It is assumed that before any funding request comes forward that it has the approval of the Associate Vice President or Executive Director responsible for that unit.
    • Look cross-organizationally for resource allocations and efficiencies.
  • Budgeting Policy and Terminology
    Budgeting and planning are done on two distinct platforms: operations and capital.
    The Operating budget is a financial plan of current operations that encompasses both estimated revenues and expenditures for a specific period, normally a fiscal year. Critical components of the Operating Business Plan are defined below:
    • A Baseline budget is defined as the steady state operating position of each unit. This reflects the resources required for a unit to provide the same level of service in the current year, before any new priorities or funding requests. Specifically included are full year salary, benefits, and other normal operating expenses, (including an allocation for capital expenses). Salary expenses in the baseline include open positions for the year (positions that have been open for one year should not be included). Re-occurring overtime and other non base compensation costs are included.
    • The Final budget includes the baseline budget as well as any onetime modifications to the current year operating plan. These onetime adjustments may be additions or deductions from the revenues and expenses of the unit. The final budget reflects how we expect actual results to look at the conclusion of the budget period.
    • Forecast actual revenue and expenditures:
      This is the projection of the current year’s actual revenues and expenses through year-end based on current operating and environmental conditions. The forecast is based on actual revenues and expenses and therefore excludes open positions and encumbrances.
    • New Priorities pertain to any material change in service level from the current business activity. This change can be an increase or a decrease in service, and does not necessarily have funding implications. Major increases in costs to continue the current levels of service are technically not new priorities, but for the sake of simplicity should be brought forward in this category if they are significant.
    The Capital Budget outlines expenditures for major equipment, software (including upgrades), repairs, renovations, and construction. These items typically have values exceeding $5,000 and have a useful life of over two years. The typical link between the Capital budget and Operating budget is a component of the Operating budget used to “pay” for these expenditures (a transfer to capital), which should be limited to depreciation expense for the current year.
    • Capital Budgets should be separated from operations by being accounted for in the Plant Fund. (Departmental Equipment for Non-Auxiliary and Plant Reserves for Auxiliary).
    • Capital Budgets require the following components:
      • Amount of anticipated actual expenditure.
      • Year of intended expenditure.
      • Useful life of the asset.
    • Capital Plans should include a minimum of 10 years for capital intensive units and 5 years for units with small equipment needs.
    • A unit that is not supported by recharges may transfer balances to departmental equipment fund with the only restriction being that it is used for items that are capital in nature.
        University of Michigan, Expenditure Review for Sound Financial Management
Financial analysis of transport corridor

Original post in Knol by me k/ financial-analysis-of-capital-and-operating-expenditures, Knol Number 646

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