Capital budget development

The objective of this article is to know the capital budgeting tool, its advantages and disadvantages, the impact it has on future investment decision-making and the development of the tool through a series of steps that allow readers to apply it later in a specific case.

When you want to make an investment, it is advisable to evaluate and select the possible investment alternatives and thus have a point of comparison between profitability and their benefits.

By evaluating the appropriateness of the different investments that you want to make, it is possible to have an overview of the implications that they would have, an estimate of the return that the investment can generate and in how long the initial investment would be recovered.

Companies usually use the capital budget in order to plan their investments, generally in the long term, having a current cash outflow but expecting future economic benefits, thus avoiding its capitalization. Almeida CI (2008).

Introduction

The capital budget forms part of the financial budget together with the cash budget, complementing the operating budget that includes the budget for sales, production, inventories of finished and in-process products, consumption and purchase of materials, while considering the budget of materials inventory, direct labor budget, manufacturing expenses and operating expenses.

Advantages and disadvantages

Using a tool like capital budgeting has advantages and disadvantages:

Advantage

It allows to set goals, objectives and delivery of results to measure the success of the project. It allows knowing who, when, where and how some task should be done. It controls the use of resources. It helps to coordinate the complicated to achieve shared objectives by a common good. It detects financial needs in advance, allowing to take measures in time. It allows the development of contingency plans for future changes or adaptations related to the project.

Disadvantages

Constant adaptation.Influence of those who make the capital budget in the results.Coarse knowledge of the subject is needed to carry out a good development of the tool.

Considering the advantages and disadvantages of using the capital budgeting tool, the impact on investment analysis and decision-making is considerably positive, therefore, it is highly recommended to use it.

The guide for making a capital budget varies depending on the author you decide to follow, for example in their book Principles of Financial Management, Gitman and Zunter (2012) explain the five interrelated steps to follow to obtain an adequate result:

Proposal development: Capital budgets are made at all levels of an organization and are reviewed by financial specialists. Proposals that require large outlays are reviewed more carefully than less expensive ones. Review and Analysis: Financial specialists conduct thorough reviews and analysis to assess the benefits of each investment proposal. Decision making: Companies generally have a financial budget that limits possible future investments. By regulating the board of directors must authorize these expenses. Implementation: After authorization, disbursements are made and projects are implemented. Tracing:It is necessary to monitor the results of each project, comparing the real costs and benefits with those planned. If these differ, action is necessary.

Basic terminology

There is some basic terminology to understand how to properly prepare capital budgets Gitman and Zunter (2012):

Projects

Independent vs. mutually exclusive:

Independent: Cash flow is not related to each other, that is, the approval of one project does not rule out the others. Mutually exclusive: Projects compete with each other for the same objective.

Limited funds against capital rationing: Availability of funds for capital investments affects company decisions.

Evaluation approaches:

Acceptance-rejection approach: Involves evaluating capital investment proposals to determine if they meet the company's acceptance criteria. Classification approach: Involves the classification of projects based on predetermined measures (ie rate of return).

Three techniques to evaluate the allocation of resources:

Investment recovery time : Time required for the initial investment to be recovered in a project.

The period may be less than or equal to the maximum acceptable and then the project is accepted, failing which it is rejected.

Net Present Value (NPV): It takes into account the value of money in investors' time.

If the VPN is greater than zero, the project is accepted, otherwise it is rejected.

Internal Rate of Return (IRR): It is the minimum acceptable rate of return that the project must cover.

If the IRR is greater than the cost of capital (TAR) the project is accepted, failing that it is rejected.

Capital budget development

When the possible investment alternatives are known, an exhaustive investigation of the project must be carried out to know all the implications and requirements necessary for development and implementation.

Data necessary to develop the capital budget

To carry out the capital budget, it is necessary to carry out a series of steps and answer the following questions:

Calculate the initial investment: In this section it is necessary to answer questions such as:

What do I need to carry out the project? How many resources do I need? How much do the resources necessary to start the project cost? What is the useful life of each resource? What is the salvage value of those resources?

Estimated income: In this section it is necessary to determine the number of years to which the budget will be made, it can be 5 years, 10 years even more. You must obtain the total investment required, the total salvage value and the value to be depreciated.

It helps to answer the following questions:

How many products will I sell during the first year? And the second and the third, etc.? What will the cost of each product be? How much should I increase the prices of the products to avoid the impact of inflation?

Variable estimated costs: In this section it is necessary to consider concepts such as annual inflation and categorize variable manufacturing costs (ie labor, raw material, indirect costs). A total unit cost and a cost of total units sold per year must be obtained.

Questions to answer:

What do I need to make my product? When will it cost me to develop the number of units sold during the year?  What indirect costs should I consider?

Fixed operating costs and expenses: In this section, fixed costs such as salaries and administrative expenses should be considered to maintain the project. It helps to answer the following questions:

How much staff do I need to develop the project? What experience does the human capital need? Based on the previous question, what salary is the right one to assign?  When should I raise the salary of the employees each year?

Financing data: This section determines where the money will be obtained to start the project, that is, the initial capital. The following questions need to be considered:

Do I have the initial capital to start the project? In the event that I do not have the initial capital, who will finance the project? What percentage of the initial capital will be financed? At what rate? At what time?

Discount rate: This section must determine the shareholders and when they want to obtain minimally each one of the project. It helps to answer the following questions:

How much should I get from the project minimally to be affordable? What is the rate of profit that investors want to obtain minimally from the project so that they decide to carry it out?

Financial evaluation

Once all the necessary data is available to develop the capital budget, the following points are developed

Determine profits, nominal cash flows, discounted cash flows, for this you must obtain:

Marginal Profit = Income - Variable costs Profit before interest and taxes = - Depreciation - Salaries - Administrative expenses Profit before tax = - Initial capital interest Net profit = - Tax (approx. 30%) Operating cash flow = + Depreciation Net cash flow = - Initial investment Discounted cash flow = Discount rate * Discount factor

Determine the equilibrium point:

Break-even point = Fixed costs / Unit contribution margin

Carry out the financial evaluation ( VPN, TIR, IR, PRD):

Per year nominal cash flow VS Per year discounted cash flow Obtain the present value of the discounted cash flows for each year. (If it is greater than zero it is accepted)

Internal rate of return of the project VS Discount rate (minimum return)

This determines whether the project is accepted or not, for this the internal rate of return of the project must be greater than the discount rate.

Assessment methods

By means of the evaluation methods it is as it will be possible to visualize the success or failure of the project, in case the project is not obtaining the expected results, decisions can be made that maximize profits as much as possible.

Among the evaluation methods are:

Cash Recovery Period Discounted Cash Recovery Period Yield Accounting Rate Net Present Value Internal Yield Rate

Conclusions

Having the possible scenarios when making an investment is of utmost importance to avoid unnecessary risks or face high risks but bet on greater economic benefits.

The capital budget is a tool that allows decision makers to have a better overview of the advantages, disadvantages and implications of a project, it also allows manipulating the possible result by carrying out variances to know optimistic and pessimistic scenarios and to be able to propose contingency plans on time.

Of course, this tool is directly related to the vision of the implementer. In the end, the implementer must carry out an investigation of the factors involved in the project and decide how much risk he wants to take, depending on the situation in which he finds himself.

Finally, measuring the actual results against the results established in the capital budget is extremely important to conclude if the project is considered successful or it is necessary to apply different strategies that prevent the failure of the project.

References

Almeida CI (2008). Capital Budget. Accountant from Peru and the World. Consulted on June 5, 2018 at: https://jlsomagar.files.wordpress.com/2008/08/presupuesto–de–pdf Chambergo GI (2009). Importance of the capital budget in investment decisions.

Retrieved on June 5, 2018 in:

http://cursoste.tecvirtual.mx/cursos/maestria/may14/ecap/ad127/programa/temas/tema4/Presu Puesto% 20del% 20capital.pdf

GARCIA Mendoza Alberto "Evaluation of Investment Projects", Edit. Mc GrawHill, Mexico 1998, p. 1.Gitman, Lawrence J. (1997). Fundamentals of Financial Administration. Oxford Univer5city Press Harla México SA de CV, Mexico. Seventh edition, 1997, p. 10075.Gitman LJ and Zutter CJ (2012). Principles of Financial Administration. chap. 10. Capital budgeting techniques. Ed. Pearson. Pp. 361-362. Consulted on June 5, 2018 at: http: //icg–com/wp–content/uploads/2015/08/LIBRO.pdf Rodríguez, M. and Ramón, A. (2014). Capital budget. Accessed June 5, 2018 at: