CAPITAL BUDGETING TECHNIQUES AND THEIR APPLICATION IN A NON-CORPORATE ENVIRONMENT
Table of Contents Page
1.0 ABSTRACT 3
2.0 INTRODUCTION / BACKGROUND 4
3.0 OBJECTIVES OF THE STUDY 6
4.0 WHY RESEARCHING WITH MUWSA 6
5.0 LITERATURE REVIEW 6
6.0 APPLICABILITY OF CBT ACCORDING TO
LITERATURE 9
7.0 METHODOLGY 10
8.0 FINDINGS AND DISCUSSIONS 12
9.0 RISKS, CHALLENGES AND MITIGATION 13
10.0 CONCLUSION AND RECOMMENDATION 14
REFERENCES 15
ANNEXTURE 16
1.0 ABSTRACT
The study problem is the Capital Budgeting Techniques and their application in a non-corporate environment (public, non for profit organization) Capital budgeting assists management decisions making on the process of making growth of the organization .It is urged that capital budgeting is useful for both non profiting organization and public sector.
The techniques are divided into two types: one, Traditional (non-discounting) that includes pay back method, accounting rate of return (ARR). Two, discounting cash flow that includes net present value (NPV), internal rate of return (IRR) Profitability Index (PI).
The findings out of the study done in MUWSA revealed that public organization does not use capital budgeting techniques since there are not oriented to investment rather are service providers. However they use alternative means or techniques of budgeting like incremental budgeting techniques because it’s a service and welfare oriented institution by its nature
It was also revealed that loans are accessed very occasionally, although decisions for investment are made to ensure operational costs are met.
The reality out of the study witnessed the capacity of the financial managers is not fully exploited in terms of applying all budgeting techniques including CBT. Therefore the study team strongly recommended the need to find some investment opportunities to support some operational costs, fully utilization of available potentials of the financial managers to ensure sustainability.
3.0 INTRODUCTION / BACKGROUND
This paper will try to cover the study on the capital budgeting Techniques and their applications in a non-profit, public organization.
Moshi Urban Water Supply and Sewerage Authority (MUWSA) is a fully autonomous but government owned entity responsible for provision of clean and safe water and collection and disposal of waste water in Moshi, the town of
Moshi Municipal is among seven districts in Kilimanjaro region has an area of 58 sq km. It lies approximately 30 180 S and 380 200 E on the southern slopes of Mt. Kilimanjaro, 5,895 feet’s above sea level, the rooftop of Africa which is snow. The mountain occupies 6% of the region land area. It is one of the tourist centres of the Kilimanjaro region and the entire north east of Tanzania.Moshi Urban district was originally established as a
Mean annual temperature is 250c while. The coolest month is July with 170c, while the warmest month is December 340c Rains are twice annually, the short once October –December and the long ones March to May of about 550 mm.
Population trend 1948 (8,048) people, 1988 (96,838), 1998 (190,000), 2002 (143,799) with a density of 2,497.3 the total number of the households are 35,596 and average population per house is 4.1. In 2006 the population was 160,841. Females 81,787 and Males 79,054.Source:
The Moshi Urban water Authority is the only water supplier in
2.1 Legal establishment
MUWSA was established under the water Ordinance CAP 281 as per the Government Notice NO71 published on 25th July, 1997.Subject to section 3(1) of the Waterworks Regulations, the Minister for Water MUWSA an Authority from 1st January 1998 and as amended by the parliament Act No 8 of the United Republic of Tanzania, thereby revoking Government Notice Nos113of 1949, 1982 and 1975 respectively
2.2 Vision
To be the best water and sewage utility in
2.3 Mission
Provision of adequate, sustainable and competitive water and sewage services to support life, social economic development and environment in Moshi, the town of
2.4 Service coverage
Water distribution: Currently the service coverage in terms of population is about 95-98%in terms of area coverage. And sewage service; the coverage is 40%, this service most covers the businesses area, the residential area the coverage is very low
Water production: The water production is 24,500m/day as compared to the total demand of 24,50m/day for an estimated municipal population of about 150,000people and its supporting economic base.
3.0 OBJECTIVES OF THE STUDY
The main objective of the study was to put into practice the analytical skills for the research methodology acquired of capital budgeting techniques at the Moshi Urban Water and Sewerage Organization. (MUWSA)
4.0 WHY RESEARCHING WITH MUWSA.
The motivation behind the study into this Government Institution was mainly because MUWSA reflected a stable organization with a solid reputation in
5.0 LITERATURE REVIEW
The Capital budgeting techniques which are under study have been defined by other schools of thoughts in financial management. The experience gained from various literature reviews have been used during this specific study at MUWSA.
5.1 Concept of capital budgeting
Capital budgeting techniques involves the entire process of planning expenditures whose returns are expected to extend beyond one year. However Pauline Weetman (1996) defines as process of management accounting which assists the management decision making by providing information on the investment in a project and benefits to be obtain from the project and by monitoring the performance of the project subsequent to its implementation.
Erasmus S Kaijage (1994) defines Capital budgeting techniques as stipulated decision rules that guide management on how to make investment decisions .According to him; they are measures of projects desirability in terms of profitability and economic feasibility. According to him, they are grouped into two categories namely conventional and discounted cash flow techniques. A conventional technique includes the Payback [PB] method and Accounting Rate of Return [ARR] method which are ad-hoc techniques that do not put the time value of money into consideration. The discounted cash flow techniques are those which take into consideration of the time value of money by discounting cash flows [DCFT] at a certain discount rate; the most widely known DCFT are the Net Present Value [NPV], the Internal Rate of Return [IRR] and the Profitability Index [PI] method.
Macmenamim J, (1999) also argued that financial techniques most commonly used to evaluate investment appraisal projects are; payback method, accounting rate of return (ARR), or return on investment (ROI), discounted cash flow (DCF) methods. In applying Discounted Cash Flow (DCF) the following techniques are commonly used; net present value (NPV), profitability index (PI), and internal rate of return (IRR). This is the process of planning and managing the firm’s long term investments. It involves identification of investment opportunities that are worth more to the firm than they cost to acquire. It is a decision on the amount and type of real assets, (buildings, machinery, equipment, etc.), to acquire.
5.2 A Conventional techniques
Conventional techniques which includes pay back (PB) and Accounting Rate of Return (ARR) method. The limitation that a had-hoc and do not put into consideration the time value of money.
5.3 The pay back period (PBP)
This is the length of time required for the stream of cash proceeds produced by an investment to equal the original cash outlay by the investment. According to Kaijage (1994) The PB period is calculating the numbers of years it takes before cumulative forecasted cash flow, equals the initial investment .The PB however has some limitations such as not discounting cash flows and thus giving equal weight to all cash flows regardless of their timing, and only considering cash flows before the pay back period
5.4 Accounting Rate of Return
ARR is an average profit after the depreciation and taxes divided by the average book value of investment. The ratio is measured against a book rate of return for the firm’s whole or against some external yard stick, such as the average book rate for the firm Limitations: ARR does not consider time value of money, hence given more weight to distant cash flow than it should.
5.5 Discount cash flow techniques (DCFT)
According to Kaijage (1994) DCFT are methods that make consideration of time value of money by discounting cash flow at a certain discount rate. This includes Net present Value (NVP), Internal Rate of Return (IRR) and Profitability Index (PI) method
5.6 Internal Rate of Return
IRR is the rate of discount for which the net value of an investment would be exactly zero. The IRR makes the present value of the cash proceeds from an investment equal to the present value of cash outlays required by the investment . IRR is the average rate of return on invested capital which the project is returning to the firm (Bringham et al 1999)
According to Hugh (2001), IRR represent the highest cost of the capital an investor could bear losing money, if all the funds to finance are borrowed and the loan (principal and accrued interest) was repaid by the application of the cash proceeds from the investment as they were earned. The decision rule is to accept project which has IRR greater than the opportunity cost .
5.6 Net Present Value
Is the maximum amount a firm could pay for the opportunity of making an investment without being financially worse off. NVP is the potential increment of wealth over alternative investments. The capital gain will be realized if the expected cash proceeds realized. NVP is interpreted to be the same as increase in the shareholders wealth (Kaijage 1994)
5.7 Present Value Index
Present Value of cash inflows by the present value of cash out flows, the decision is to accept a project with PI greater than one
6.0 APPLICABILITY OF CBT ACCORDING TO LITERATURE
6.1 Use of CBT in Financing Decisions
The capital structure decision, concerns the ways in which the firm obtains and manages the long term financing it needs to support its long‐term investments. It involves two important questions: how much should the firm borrow (amount, maturity, and mixture) and how, and where from, to borrow.
6.2 Working Capital Decision
This is a continuous operating decision that finance manager take in day‐to‐day operations. It involves such questions such as; does the firm have adequate cash or access to cash, e.g. through bank borrowing agreements, to meet its daily operating needs? Which customers should be offered credit and how much should they be offered? How much inventory to carry?
7.0 METHODOLGY
1.) Contracting stage. The group members convene a sharing meeting to sort out the best way to engage as to ensure the best output out of the research process.
This session was done on the 27th May 2008.
The members agreed on the study objectives and the organizations for the analysis were identified.
o The first choice which came into the group mind was Mkombozi, children center. This was nominated simply because it’s a big organization which covers two regions Arusha and Moshi. The visit to this organization was done and unfortunately that period they were undertaking their annual auditing process. They requested us to revisit them after a week so that we can proceed with the process. The following week the visit was done and just to realize that they not practicing capital budgeting techniques, as they are donor dependent.
o The second organization was
The Mkombozi center referred us to Amani simply since they have already
constructed new premises in 2007. Unfortunately they were also not practicing
capital budgeting techniques also they are donor dependent
o Lastly the group sorted out to work with MUWSA. Visiting MUWSA, the first reception was to be asked to write an official letter for requesting the authority to allow the study to be conducted. The group wrote the letter and just to realize a response from the Director that this study was not permitted. One of the group members because of having an individual family relationship with the Director decided to directly visit the director and try to convince him for this study. He lastly allowed the study to be conducted. The experience of this stage took almost two weeks to settle the specific organization to work with.
11). The descriptive type:
The study methodology at MUWSA mainly uses. This was very important for the process since it offered an opportunity to ask more questions for clarification and also to re-check the issues shared. Question for the interview were structured and set for the discussion. The process was conducted mainly by interviewing a cross section of the Accounting section leaders 4 people, the Management 2 people, some board members 1 individual and the beneficiaries of the service water users 5 people. A total of 12 individuals were interviewed.
111). Secondary data Source
This was collected by reading much of the reports and other MUWSA documents. Much of the background and introduction information was collected out of this process.
8.0 FINDINGS AND DISCUSSIONS
I. CAPITAL BUDGETING TECHNIQUES
The water authority does not always use the capital budgeting techniques since it is service oriented they mainly use they the incremental budgeting techniques. They always consider an increment of 5% on annual basis.
Explanations given was service comes first, for instance if a certain area needs water the decisions are not made for the returns or profit, but rather service to be offered. Further it was argued that their investments normally took long time for returns to be realized. The water bills for customers they calculated only to ensure the operational cost are sustained
II. COST OF CAPITAL
This can be defined as the minimum rate of return a firm is required to earn on its investments in order to satisfy investors and maintain its market value.
The Investors required rate of return. The firm project can be financed by debt, such a long-term loan or debtors and equity. MUWSA took a loan from CRDB bank Moshi Branch .The loan was taken simply because there were some local people who needed compensation due to the effect of being transferred from their original traditional land places due to the reality that they were residing on the apex of most of the water sources like Shiri area, Kibosho and slopes of the Uru North village.
The loan collected was5 billion they pay bank 150,000,000/= every month. Interest rate is 14% so pay back period is applied.
III. TAX
Effects of tax: The organization does not pay tax since it enjoys an exemption. They pay normal deductions such as PAYEE, NSSF for the staffs only
IV. DETERMINING THE CASH FLOW
Cash flows are determined using cash budgeting and planning using incremental budget technique within the specified period, such as quarterly or yearly etc. The organization prepares their cash flows taking into consideration the operational costs, so the prices for water for the customers are considered;
V . INFLATION: They also take care of inflation by adding some percentage.
VI . DEPRECIATION
The organization does depreciation to the office assets such as cars, office furniture and the like. They use the straight line method source- from the audit report.
9.0 RISKS AND MANAGERIAL CHALLENGES AND WAYS TO MITIGATE THEM.
o Inconsistent payment of water bills by clients as indicated in the interview and discussions done by the key informant people.
o Increasing running costs for the digging furrows which has no a fixed payment rates. The laborers are the casual laborers who are paid on daily basis and the rates differ according to the nature work which is going to be done.
o The costs for paying the regulatory board which is EWURA is also very high. They have set a percentage for the fees to be paid regardless of the situation that they need to re-examine the revenues.
o The organization foresees risks in terms of anything that can happen to hinder not to deliver the services for example if serious earthquakes comes and destroys the boreholes then it will be a major catastrophe.
o Risk associated with not receiving enough water due to environment degradation such as deforestation and people living near water sources. The frequency of the fire burning in the forests of Mt Kilimanjaro area still remains a major challenge for this process.
o Also another risk is if big consumers like industries if they seize to use their services or clients not paying their bills.
9.1 Mitigation
The way forward in terms of the said risks mainly focus ongoing reminder of clients responsibility taking by paying water bills. Also, the continuous education process which will ensure better understanding of the local people. The community involvement in protecting and conservation process of the environment will ensure the long-term solution to the risks. Enhancing strategic networking with other organizations working with environmental aspects will ensure long term solution. Tree planting programme around the water reserves, boreholes could also form part of the strategic way forward
10.0 CONCLUSION AND RECOMMENDATION.
The Institution is purely service/welfare oriented. It offers safe and clean water to more than 150,000 citizens of the Moshi Municipal. The use of capital budgeting techniques was not consciously considered in this institution. However, the analysis revealed that they use some of the CBT processes such as loan payback, Incremental budgeting techniques.
The institution being a non profit and governmental oriented however, we strongly urged that there is a need to think on other simple investment opportunities to ensure the constant income which can ensure easy tracking of the returns in terms of investment.
Experienced gained from the MUWSA, It was only the struggle to service the bank loan which was reflected by the organization. Ensuring the payback of the loan in a period of 5 years was the main focus of the institutional plans. The means to generate and increase internal income for the institutional sustainability wasn’t well articulated. MUWSA is however strongly recommended to think of a possibility of having a project whose internal rates of return will be greater than the cost for servicing the bank loan.
REFERENCES:
1. Erasmus S. Kaijage (1994); Capital Budgeting Practices in
2. Hand outs by Dr Proches Ngatuni – Strategic Financial Decision – Making (part four)
3. James Van Horne (1980), Financial Management and Policy 5e,
4. McMenemic Jim, (1999) Financial Management an Introduction,
5. Pauline Weetman, (1996) Financial & Management Accounting an Introduction Pitman Publishing
ANNEXTURES
Capital budgeting techniques – questionnaire
This questionnaire is part of the research on the application of the Capital Budgeting Techniques in not for profit organization. It is for the purposes of studies only.
Please feel free to ask any question.
A: Background Information of the Organization
1. What is the name and address of your organization?
………………………………………………………………………………….
2. How would you describe the ownership of the organization?
……………………………………………………………………………………...
3. What is the purpose of your organization?
………………………………………………………………………………………
4. What product or services does your organisation provide? (sales, trade, volume)
………………………………………………………………………………………
5. How many employees does the organization have?
………………………………………………………………………………………
6. What geographical area does the organization covers in its operation?
………………………………………………………………………………………
7. What is the total value of assets owned by the organization?
………………………………………………………………………………………
8. How capital investments are financed (Capital Structure)?
………………………………………………………………………………………
9. How is the water sector governed? Policies, laws, etc)
10. How does the MUWSA differ form other water suppliers in other towns. What are you proud of? What I unique with MUWSA?
B: Capital Budgeting Techniques:
1. Which of the following types of capital budgeting techniques do you use to evaluate investments?
________________ Net Present Value (NPV)
________________ Internal Rate of Return (IRR)
________________ Pay Back Period (PBP)
________________ Profitability Index (PI)
________________ Accounting Rate of Return (ARR)
________________ Other (specify) ………………………………………………..
2. How frequent do you use these techniques?
__________________ Annually
__________________ Quarterly
__________________ Monthly
__________________Other (specify) ………………………………………….
3. Do you use a single or a combination of techniques?
________________ Single (which one?)……………………………………….
________________ Combination (which ones?) ……………………………..
4. Do you consider one of the techniques support? Why?
________________ Yes (why)…………………………………………………
________________ No
5. Is there any techniques relied upon by the organization in making investment decision?
_________________ Yes (which one?) ………………………………………
_________________ No
6. What is the most difficult technique to apply? Why?
……………………………………………………………………………………...
7. How do you apply techniques in different sizes of investments/projects?
………………………………………………………………………………………
C. Cost of Capital (Discount Rate):
Are any of the following used in capital budgeting in your organization?
________ 1. Cost of borrowing (explain)…………………………………………..
_________ 2. Interest Rate (explain) ………………………………………………
_________ 3.Cost of Equity (explain) …………………………………………….
_________ 4.Capital pricing models (explain) ……………………………………
__________ 5. Weighted Average Cost of Capital (explain) ……………………...
_________ 6. Internal Rate of Return (explain) ………………………………….
…………... 7.Other criteria? Or adjustment to above method.
D: Risk Analysis and Control
1. How is the risk considered in project analysis?
………………………………………………………………………………………
2. What approaches are used to mitigate potential impact of risks?
………………………………………………………………………………………
E: Other Variables:
1. How are the cash flows determined?
……………………………………………………………………………………..
2. How are the effects of taxation and inflation adjusted?
…………………………………………………………………………………….
3. How are Interest expenses treated?
……………………………………………………………………………………..
4. How is depreciation treated?
………………………………………………………………………………………
5. What are the problems facing you as a manager in making investment decision?
………………………………………………………………………………………
No comments:
Post a Comment