In our days, starting a business turns out to attract many questions, the one that worries us most as entrepreneurs, without a doubt, is whether the business will be economically profitable to pay debts, wages and make profits. Therefore, the elaboration of a capital budget is too useful a tool to analyze the suitability of an investment project or a business.
In the course of this essay, we will mainly explain the capital budgeting process in order to provide entrepreneurs with an overview of the variables to take into account in this type of financial analysis for more reliable and accurate decision-making. in the undertaking of their businesses or investments.
We will mention some important variables that determine this feasibility in our project, such as the interest rate and the risk-free rate.
We will explain further in the development of this work the models or rules on which the financial evaluation of a project is based, such as the VPN, TIR, IR and PRD.
Finally, in our conclusions, we will highlight the importance of preparing or analyzing the capital budget of a new project or, in the modification or improvement of an existing one.
Development
As a first step, it is necessary to calculate the initial investment, that is, the total resources required to generate our project. These range from fixed assets achieved or planned to be purchased in the future as an example can be: land or building, machinery, plant and equipment, to the working capital necessary to start activities.
Every fixed asset has a salvage value. Normally this value is given by the financial advisor or by the manufacturer. They also have a depreciation value or an appreciation value. These are a function of the time and conditions of use of said good. It is necessary to take them into account, since although they will be reflected at the end of the life of the project, they will result in a return on investment.
The estimated income will be an important part, therefore, it is necessary to define goals based on a market analysis. These are a function of sales during the life of the project and the variable costs of the product. Normally, a positive linear growth is inferred for both, since, as the years go by, you tend to gain more experience, therefore, you will sell more your product, but it will also cost you more to produce it.
Variable costs are all those that are necessary to produce the product. That is, labor, raw material, indirect costs, etc. These, as we have already said, tend to increase like the vast majority of products or services in our country, since they are affected by the inflation index. So it is expected to at least cover this index in the sale price of our product to generate profits.
All costs and expenses other than variables are called “Fixed or operating”. To name a few examples, annual salaries for trusted employees and administrative expenses are included in this category.
So far and while we have the capital to absolve our initial investment, it seems that everything is running well, however, many times otherwise, it is advisable to leverage financially to achieve our objectives faster.
Leveraging in financial terms means borrowing. This is where the intervention of investors or partners can be of great help. Said debt is taken into account in our analysis, and it is vitally important to absorb the costs or the interest within the determined period to amortize the initial investment.
But how much to borrow? Without a doubt, it depends on the convenience of investing your own money or reserving it for another type of concept.
Thus, the TREMA or minimum acceptable rate of return is calculated based on the percentage contributed by the partners or by a banking institution, taking into account the percentage points that they have estimated as a reward for risk and the risk-free rate provided by the certificates of the treasury of the federation "CETE", (http://www.banxico.org.mx/portal-mercado-valores/index.html, sf). For practical terms, we will try to describe CETE as the loan of money that you give the government when acquiring them so that it can pay its commitments, and in return you take a profit or interest.
So, making the product of these two rates we will find the minimum acceptable rate of return for the project (TREMA). In the end we will end up weighing against the participation percentages of the parties to find the discount rate or weighted TREMA.
Later we will determine the profits, nominal and discounted cash flows in the projection in the determined time to amortize the investment. The net profit is obtained by subtracting from marginal profit, the depreciation of assets, administrative expenses and of course the interest payable to the bank and the government (ISR).
The operating cash flow or the cash we need to operate our business is the sum of the depreciation plus the net profit. So, using the TREMA weights and a discount factor to the number of years to pay the debt, we find the discounted cash flow. This is necessary because the cash flows in different periods cannot be compared directly since it is not the same to have an amount of money now than in the future.
The breakeven point refers to the level of sales where fixed and variable costs are covered. These will be absorbed from a percentage from the marginal profit to pay the fixed. The rest is considered to pay the variable costs.
The equilibrium point in units is the result of the sum of the fixed costs between the sale price of our product, (Zutter, 2012).
As the last step of our analysis, we will focus on the financial evaluation of the project through the 4 rules or principles VPN, TIR, IR and PRD, (Van Horne, 2010).
So thus, adding the discounted flows we can obtain the net present value (NPV). If the present value of the cash flows is greater than zero, the project is accepted (Van Horne, 2010).
The recovery period (PRD) is calculated by subtracting the initial investment and the discounted cash flows. If they consider as feasible if a positive difference results to zero, (Van Horne, 2010).
Additionally, it is necessary to corroborate the financial feasibility through the calculation of the internal rate of return (IRR), this must be higher than the minimum discount rate to be able to accept the project, (Van Horne, 2010). There are easily understood computational formulas to calculate it.
Finally, the profitability index (IR) is calculated, that is, the weight you get for each peso invested. This is obtained by dividing the sum of discounted cash flows by the profitability index, if it is greater than 1, the project is accepted (Van Horne, 2010).
Conclusion.
Nowadays, financial analysis is very important before starting a business or an investment, since these provide us with a broad overview of financial behavior during the life of the project. This helps us and gives us better decision-making power when in doubt or uncertainty.
The lack of financial knowledge often causes us to err in our decisions, focusing our resources also in an inappropriate way. This can attract delays and many expenses not considered at the beginning of the project. Tools such as capital budgeting clarify doubts, especially if the project will be sustainable over time.
This type of procedure is difficult to understand at first glance, however, with a little practice it ends up being too practical. Today there are many applications on the internet that can help you to generate it and of course, this essay can serve as a good reference to understand the concepts and the steps to follow in one of them.
Bibliography
www.banxico.org.mx/portal-mercado-valores/index.html. (sf).
James C. Van Horne and John M. Wachawicz, J. (2010). Fundamentals of financial administration. Prentice Hall.
Zutter, LJ (2012). Principles of financial administration. Pearson.
