Capital budget proposal for a new day room

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CAPITAL BUDGET PROPOSAL 1

A RESEARCH PROJECT ON CAPITAL BUDGET PROPOSAL

ON NEW DAY ROOM

PRESENTED BY:

DATE OF SUBMISSION:

Contents

BACKGROUND

Project proposal for a new day room for the local community:

Items to be evaluated in terms of cost:

Examine key sources of finance and expenditure from financial statements and management accounts:

Types of funding

Analysis of the Financial Data in an Organizational Context:

Budget forecast and review statements:

Evaluation of Both projects using appraisal techniques

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Return on Investment

Payback Period

DCF Schedule

Analysis of the various methods of capital investment appraisal:

Main factors when considering a project when there is a choice to be made:

Project justification

Examine key issues in the management of change:

Nature of Change and Cost Details

Reason for Change

Authorization

Conclusion:

References

BACKGROUND

The local community has a decision to make that pertains having the best facility for their children in the day care center. The community has an urge of coming up with the best alternative for the above solution and is considering two options available, i.e. to construct a new building from ground up or renovating an old building already existing in the site. Both entail expenditure that the management committee is trying to cut down to minimal.

As a financial analyst, they approached me to come up with an evaluation and analysis on the two projects. Their estimated cost to be incurred through the project is £60000 to complete the project. Considering the cash flows on both renovation and construction expenditure, I will evaluate and advise accordingly on the most viable option to undertake.

Factors to consider is that, there are factors to be kept constant however which alternative is used to complete the project. An assumption of fittings and furnishings will be the same and the day center will occupy approximately 15m by 20m. The other fact is that whichever option used, the room has to conform with all health and safety measure and all standard regulations for the type of use.

The community is considering whether to expand the space, moving from existing space or developing from the same site, a thorough analysis of space needs should be conducted.

Factors to consider whether to construct or renovate the center apart from the financial analysis on capital budgeting includes the following:

  • Suitability of space: The space which is beneficial for the parents to pick and drop their kids. The place should also be in a safe environment. There should be no rush of traffic near that place. This will keep the children more safe and secure.
  • Urgency of need in time frame as construction takes more time as compared to renovating the same building. Before deciding that whether room should be constructed as new one or should be renovated, it is important to consider that whether the budget is suitable or not (Barr & McClellan, 2011). Most probably the chances are that the less budget will be needed in the renovation of the room as compared to the new construction of the room. But we cannot rely on this supposition. That is why we have to check out the feasibility of the project b the Investment Appraisal techniques and the capita budgeting (Akintoye & Beck, 2009).

Project proposal for a new day room for the local community:

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The community is considering an investment program. It has a choice of two projects each of which costs £ 60000, but the capital is limited in supply to £60000. Following is given the complete details of the budget of the project as per duration of the project.

Project A –renovation of building

Project B- construction of a new extension.

Time in months.

Forecasted cash flows

Forecasted cash flows

1

18000

24000

2

12000

27000

3

21000

15000

4

21000

15000

5

19500

9000

Totals costs

91500

90000

NPV FACTOR=15%

MONTH

1

0.870

2

0.756

3

0.658

4

0.572

5

0.497

Items to be evaluated in terms of cost:

The following are the important items which need a cost and budget analysis:

  1. Construction of a new extension
  • Building materials-concrete, ballast and bricks,
  • Furniture s and fittings,
  • Air conditioning devices,
  • Effective fire safety equipment.
  1. Renovation of existing building
  • Building materials, new roofing materials.
  • New furniture and fittings,
  • Air conditioning system
  • Fire safety equipment,
  • Lockers and cabinets.

Examine key sources of finance and expenditure from financial statements and management accounts:

Types of funding

The community has to consider having multiple sources of funds to avoid lagging the project to its completion. There are several sources at which it can source these funds. Departmental funds, income from operations of day center, or grant funding which is typically good when leasing is an option and this kind of small renovation project (Dayanada, 2002).

In some cases, the contractor will be willing to provide up-front construction or renovation funds and either absorb the cost over the length of a long-term lease, or amortize the funding by increased rent over the life of the lease (Froot, 2003). Some leases are structured to provide a payment of the unamortized balance of construction costs if a lease is terminated early by the community committee.

Some of the potential sources of funding within the health and social care services of such project is the local government (Holland & Torregrosa, 2008). The committee can ask for grants from the government in the department of health and social services do the project. The local government will offer this fund in cash flow basis and in phases and expect a refund within a speculated time period. Internal loan (inexpensive facility), revenue bonds (expensive facility), or reserves available Departmental funds, internal loan, or bond financing available are the most viable sources of funds to funding this project.

Analysis of the Financial Data in an Organizational Context:

Based on the budget constraints, the building committee has to ensure they have the most viable project at hand to undertake this goal (Paramasivan & Subramanian, 2009). Based on the cash flows, the project has an initial high capital start rate.

Financial data allows us to understand that which project is revenue generated. If he project is revenue generated and it has lower payback period only then the project should be accepted (Peterson Drake & Fabozzi, 2002). Otherwise, the project can go for a loss. When we have to choose from two different projects, then we need tp consider several Financial Appraisal techniques. These financial appraisal techniques are: IRR (Internal rate of return), ROI (Return on Investment), NPV (Net Present Value) and Annual payback period. Each technique has its own advantages and disadvantages. The most appropriate techniques considered are Payback period and NPV (Saita, 2007). The projects with higher NPV are always good to generate good profit. The projects with lower payback period are more beneficial. As they will give more profit and will return the actual investment in less time period.

Budget forecast and review statements:

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The budget in clearly strained in this context as far as the project funding and availability of funds is concerned. There is no expectation of rise in cost of materials and if so, a very significant rises to stretch the budget further (Tripathi, 2008). Since they are the only two available options to be undertaken, the budget has to be limited to accommodate the project.

If we have to run the project smoothly, then we have to take care of al aspects of the cost and budget before hand (Vogt, 2004). This will enable us to perform all the functions smoothly during the process of renovation or construction. Still, if there comes some unseen circumstances, then we will be able to handle the matters only then if we have pre-hand estimations of the budgetin and cost analysis. “Sound capital investment decisions require a great deal of care in order to match facility capacity with program or service needs. Capital investment errors—whether unproductive excess capacity, restrictive under capacity, or deferred maintenance—have become prohibitively costly. Louisiana's capital outlay planning and budget process responds to the need for informed, results-oriented capital investment decision-making.”- (Capital Outlay Planning and Budgeting COP&B-3)

Evaluation of Both projects using appraisal techniques

Return on Investment

The return on investment method expresses the average annual profit earned over the life of the project as a % of the initial capital outlay or the average capital outlay.

Project A

Project B

Cash flow

91500

90000

Depreciation (20% straight-line)

60000

60000

Incremental Profit

31500

30000

Average profit

6300

6000

% of initial outlay

10.5%

10%

This method can be easily understood but has two main weaknesses. These weaknesses are as follows:

  • It ignores cost of capital
  • The timing of the cash flow is also ignored in this technique.

Hence, this technique cannot be considered as an accurate one.

Payback Period

This is the measure of time it takes to recover the original outlay and is usually defined as the number of years it will take for the cumulative cash flow from the project to equal the capital outlay. This method is considered as the important and accurate one. As this gives us clear information that how much time will be needed in order to gain the money invested on the project.

Month

Cumulative cash flows

Project A

Project B

1

18000

24000

2

30000

51000

3

51000

66000

4

72000

81000

5

91500

90000

Calculations of Payback period

Project A

Payback period = 9000/21000X 12

=3 months 5 Days

Project B

Payback Period = 9000/15000X12

=2months 7days.

DCF Schedule

Project A

Project B

MONTH

NPV FACTOR

NPV

CASH FLOW

CASH FLOW

NPV

0

1.000

(60000)

(60000)

(60000)

(60000)

1

0.870

18000

15660

24000

20880

2

0..756

12000

9072

27000

20412

3

0.658

21000

13818

15000

9870

4

0.572

21000

12012

15000

8580

5

0.497

19500

9693

9000

4215

NPV

255

4215

As each project has a positive NPV they are all achieving a rate in excess of 15%. Now we will take a look that which project has higher NPV. The project with higher NPV will give us more profit.

Project B has the higher NPV and is therefore achieving the highest return. If a decision to adopt was made purely on a financial perspective then project B would be the first choice.

Analysis of the various methods of capital investment appraisal:

As a financial analyst, I would engage the committee to a number of capital investment techniques. This technique will help us to get to know that which project is more suitable and which should not be adopted. These techniques are:

  • Average return on investment
  • Payback period
  • Discounted cash flow – NPV, Net Present Value Method
  • IRR – Internal Rate of Return

Main factors when considering a project when there is a choice to be made:

There are certain factors which needs to be consider which choosing the right project. These factors are given below:

  • The amount of capital available and the source of capital
  • Cost of capital
  • The life of the project
  • The cash flow from the project or projects and its timing
  • Capital allowances and taxation
  • Grants
  • Residual value of the asset

The objective of this case study is to examine an investment and measure its performance using the following techniques:

  • Average return on capital
  • Payback period
  • DCF – NPV method
  • IRR – Internal Rate of Return

NB: The existing return on capital is 15% and in this case this is assumed to be their cost of capital for appraisal purposes.

Payback Period

This is the measure of time it takes to recover the original outlay and is usually defined as the number of years it will take for the cumulative cash flow from the project to equal the capital outlay.

Although this method does give weighting to the timing of the cash flow, it fails to take account of the cash flow after the capital has been recovered and does not relate to cost of capital.

Discounted Cash Flow

To calculate the DCF return, a rate of discount is assumed, this usually relates to the cost of capital or the target return required. The present values of all the future cash flows are listed by multiplying the cash flow for each year by the appropriate discount factor.

The aggregate of these present values is then compared with the initial outlay and the NPV – net present value is determined. If the NPV is positive then the return achieved is greater than the rate at which the cash flows have been discounted, and therefore the project would be acceptable.

Conversely if the NPV is negative then the rate of return is less than the rate at which the cash flows have been discounted and therefore the project would be rejected.

IRR – Internal Rate of Return

IRR stands for Internal Rate of Return. This gives us an idea about the profit which the project will yield during its lifetime. In order to determine the rate the project is achieving we need to consider the IRR. The IRR is simply that % discount rate at which the NPV would be equal to zero. That is where the cumulative present values equal the initial outlay. Te projects with more IRR are always useful.

Return on Investment

The return on investment method expresses the average annual profit earned over the life of the project as a % of the initial capital outlay or the average capital outlay.

This method is easily understood but has two main weaknesses as it ignores both the cost of capital and the timing of the cash flow.

DECISION ASPECT:

Project B has the higher NPV and is therefore achieving the highest return. If a decision to adopt was made purely on a financial perspective then project B would be the first choice. This project will give more profit than Project A.

IRR – Internal Rate of Return

In order to determine the rate the project is achieving we need to consider the IRR. The IRR is simply that % discount rate at which the NPV would be equal to zero. That is where the cumulative present values equal the initial outlay.

In the case of project C we need to discount the cash flows at a higher rate.

Project C

MONTHS NPV Factor 20% Cash Flow NPV

0 1.00 (60000) (60000)

1 0.833 24000 19992

2 0.694 27000 18738

3 0.578 15000 8670

4 0.482 15000 7230

5 0.401 9000 3609

NPV: (1761) As the project, when discounted at 20%, has a NPV of (£1761) negative, it is not Achieving that discounted rate of return.

Project justification

There are many benefits accrued from this project when the whole project will be complete. There is improved quality, availability and support of academic programs to the local community. This project will meet the need for space as documented above, it will also accommodate special facilities, and any other activity relevant for the children who will be using the building.

The new facility will hub multiple activities relevant to the kids in terms of academics, physical exercise, social interaction and more so, considering the health measures and safety regulations speculated as a requirement within the center.

The project has to take effect as scheduled and completed within the estimated time frame without which, there are consequences to be faced by both the community and the contractors handling the project.

The default plan will take phases to enable tracking of progress and monitor laxity within the project period. This will help the project committee and unit managers to have an estimate on time and evaluate schedule according to plans.

Limitations of alternative models for evaluating expenditure:

There are several models at which the expenditure can be evaluated apart from using the method above. There are several limitations that accompany these models of evaluation. Some of these limitations are mentioned below:

  • They don’t evaluate on time and estimation on expenditure.
  • They are usually technical in such simple projects, lack of simplicity.
  • The need for financial speculation is neglected and other forces and factors are considered leaving the project under financial crisis at most times.

Examine key issues in the management of change:

Nature of Change and Cost Details

Every project has vulnerability to changes as change is inevitable. The changes in this aspect are based on rates on capital, market prices on materials, labor forces and fluctuating financial cycles. Changes also can be implemented by the management or committee whenever possible.

Amendments can be made on the original document and plan based on these faced changes. However, the factor on budget constraints should be put into actualization so as not to overstretch the budget and hence, slow down the project phases.

The amendment can relate to time extension that can cross even financial years and also it can relate to total project cost. The imporrat thing which needs to be consider before any amendment is the fiscal year. If the time priod of the project is more than the fiscal year, then the committee have to change the starting date of the project as well as it has to propose a new scheduled date for the project.

Reason for Change

The overspending can be caused by time schedules and target as intensive labor can be used to minimize on time set. The steps which will be adopted to reduce the extra cost are financial based activities to cut costs of recurring items. The reason of the start of the project before the scheduled date should be mentioned if it relates to the extensions of the time period of the entire project.

Authorization

It is essential that the final approval of the authorization by the higher authorities should be taken before making any kind of changes in the proposed plan. If the decision has to be made about the more use of the cost as it was planned, and then the approval of the authorization is mandatory. No amendment can be made without the consent of the approval authority.

The project plan is to be developed by the team to incorporate expenditure, milestone budgets and timescales. Factors on the same effect are management control and control measures.

Conclusion:

From the above discussions and the financial appraisal techniques, we can conclude that the Project B, i.e. the renovation of the new room is more suitable as compared to the Project A, i.e. construction of new room. The Project B has more NPV and its payback period is also less. Hence, this will generate more revenue.

References

Akintoye, A., & Beck, M. (2009).Policy, finance & management for public-private partnership. Oxford: Wiley-Blackwell.

Barr, M., & McClellan, G. (2011).Budgets and financial management in higher education. San Francisco: Jossey-Bass.

Dayanada, D. (2002).Capital budgeting. Cambridge, UK: Cambridge University Press.

Froot, K. (2003).Risk management, capital budgeting and capital structure policy for insurers and reinsurers. Cambridge, Mass.: National Bureau of Economic Research.

Holland, J., & Torregrosa, D. (2008).Capital budgeting. [Washington, D.C.]: Congress of the U.S., Congressional Budget Office.

Paramasivan, C., & Subramanian, T. (2009).Financial management. New Delhi: New Age International (P) Ltd., Publishers.

Peterson Drake, P., & Fabozzi, F. (2002).Capital budgeting. New York, NY: Wiley.

Saita, F. (2007).Value at risk and bank capital management. Amsterdam: Elsevier Academic Press.

Tripathi, M. (2008).Auditing and finance management. New Delhi: Navyug Publishers and Distributors.

Vogt, A. (2004).Capital budgeting and finance. Washington, D.C.: International City/County Management Association.

  1. Policy 71 - Capital Funding for Construction and Renovation Projects