Capital budgeting requires several interrelated concepts. Therefore, the objective of this work is to clarify some definitions in general using simple language. The reader can later delve into a concept that you want. The main thing is that you get a clear and brief idea of how to prepare a capital budget. This tool is very useful for making decisions about an investment project.
Introduction
Sometimes the need arises to carry out an investment project in order to increase capital. For this, the financial administrator requires evaluating the project to determine if the project is profitable or not. That is, if the money flows show enough profit with the objective that the project will exceed costs and be sustainable in a time interval.
The objective of this work is to explain concepts in a general way in order to prepare the capital budget.
But what is a capital budget?
According to Gómez S. (2015) “The capital budget is the process of planning and managing the company's long-term investments. Through this process, the managers of the organization try to identify, develop and evaluate investment opportunities that can be profitable for the company. It can be said, in a very general way, that this evaluation is made by checking if the cash flows that the investment in an asset will generate exceed the flows that are required to carry out said project. ”
In order to carry out the evaluation, it is necessary to have a clear understanding of the concepts required to prepare the capital budget. In general, it is necessary to collect the basic data of the investment project, such as initial investment cost, estimated income, variable costs, fixed costs and financing data.
Finally, the financial evaluation will be explained, which consists in evaluating the money flows against the indicator of net present value or the IRR.
Initial investment
An initial investment is understood as the disbursement of the person or company that is required when starting a project, without taking into account future expenses. In this aspect, the costs of the fixed assets to be acquired, working capital, salvage value and depreciation must be considered.
Fixed assets are the assets that are acquired to create a product or service, such as buildings, machinery, land, plant and equipment. All assets have a salvage value, which at the end of the project can be sold at a lower price than what was purchased.
Also, some of the fixed assets may have depreciation or loss of value. Depreciation is a financial calculation that gives the benefit of declaring an additional expense to reduce the amount of taxes to pay.
Working capital will be the amount of money needed to support variable costs in the event of no sales. In other words, it is the minimum short-term investment to operate, or it can be seen as the initial balance of the bank account. This amount can be estimated according to the estimated level of sales. For example, the project is expected to have no sales in the first two months, so it would have to be calculated how much money would be needed to cover the variable costs.
Estimated income.
The financial manager should estimate how many units will be sold each year and at what price. This will determine the estimated sales for the project. For this, prices must consider the inflation percentage for the following years.
Variable estimated costs.
According to Riquelme M. of webyempresas.com, variable costs are those expenses that vary in proportion to the activity of the company. Variable cost is the sum of all marginal costs per unit produced. Thus, fixed costs and variable costs constitute the total cost. They are usually called costs at the unit produced level, since they vary according to the number of units produced.
It can be said that they are the costs associated with production. Costs vary according to sales volume. For example, raw materials, labor, energy, fuels.
Fixed costs and expenses.
Riquelme M. from webyempresas.com also mentions that fixed costs are those expenses of the business activity that do not depend on the level of production. The administration usually refers to them with the term "general expenses". They are not fixed permanently, as they tend to change over time, but this change will not depend on the amount produced for the period in question, therefore, they make up those costs that the company must pay regardless of their level operating, that is, whether or not these payments are due. Conceptually, a fixed cost is a disbursement in which the company compulsorily incurs, even when it operates in mid-gear, or in the worst case, it does not operate for any reason of force majeure. For this reason, they constitute a serious problem for companies,especially when for some reason, your productivity and income decrease.
These are costs that are independent of production that, even if there are no sales, would have to be paid. For example, administrative salaries. They also include administration costs such as telephone, internet, rent, fuel.
Financing data.
For these data it is necessary to define where the money will be obtained to finance the project. The owners of the company could contribute their own money to invest it. In this way they would remain as shareholders and the level of decision-making would depend on the percentage of contribution. Another option is to get a bank loan where the bank defines a discount rate that the project requires to ensure that the credit can be repaid. This discount rate is the minimum percentage that the project must contribute as profit.
“The concept that underlies this definition is that if I have € 1,000 today and I leave them in a drawer, when at any future time I take that money and want to buy products and services, I will be able to buy fewer products than if I had spent them today " Vicente Esteve (2017).
The rate should consider the risk-free rate, for example, Cetes, plus a percentage of reward for risking money. This rate is usually called Trema (Minimum Acceptable Rate of Return).
The Federal Treasury Certificates (CETES) are the oldest stock debt instrument issued by the Federal Government (Banco de México (1999).
Financial evaluation.
In the first step, earnings per year need to be calculated, both nominal flows and discounted flows. Nominal flows are the amounts that the project will give as profit in the future. However, these flows will have a lower value in the future due to inflation, so discounted flows need to be calculated. Each amount in the future needs to be brought into the present using the present or present value (PV) formula. Once the discounted flows are obtained, the value of the initial investment is added and subtracted, resulting in the net present value (NPV). If the net present value is greater than zero, the project is accepted, otherwise it is rejected. There is also another way to evaluate the project, using the IRR. The IRR is the minimum rate where the net present value is equal to zero.If the discount or trema rate is higher than the IRR, the project is accepted, otherwise it is rejected.
In addition, it is important to obtain the break-even point, which is the level of sales required to cover fixed costs and variable costs. For this, all the fixed costs can be added and divided by the marginal profit percentage, which is the profit obtained by discounting the variable cost. The advantage of breakeven is that it can help set sales goals.
Finally, it is necessary to make a bank loan amortization table showing the initial balance, the payment of interest, the principal payment and the final balance in the duration of the project. The purpose of this is to control the flows of money until the debt is settled.
Investment strategy.
One of the strategies in the investment project is to seek to reduce the initial investment so that the project is more profitable, that is, to spend less money at the beginning. You can also look for the bank to charge a lower interest rate on the loan.
References:
- https://www.enccyclopediafinanciera.com/definicion–costos–variables.html Gómez, S. (2015): “Capital Budget”. Obtained from: https://es.slideshare.net/Sonialineth27/presupuesto–de–capital–43695504 http://educa.banxico.org.mx/mis_finanzas/guia-mi-presupuesto-mis-finaz.html https: / /www.webyempresas.com/costos–variables/ http://vicentesteve.com/
