Large corporations or companies have a specific area of finance, with personnel that have extensive knowledge on the subject and are exclusively dedicated to making financial decisions for the company: do we bet on such a project or not?…. do we open a new plant or not? …… we promote a new brand or not? But many small and medium-sized companies do not have such areas, which results in the making of these types of decisions is in the hands of personnel or managers with little experience in such matters, after all, the ideas are easy but implementing them is the complicated thing..
By definition, companies must seek the projects and opportunities that enhance shareholder value. However, because the amount of capital available at any one time for new projects is limited, capital budgeting techniques need to be used to determine which projects will generate the highest returns over an applicable period of time. For these reasons, we propose a brief guide on how to make a capital budget and what could be some of its limitations.
Preparation of the Capital Budget
The first step involves selecting the type of project to establish. Then the assumptions under which the financial analysis will be carried out (economic conditions, growth, employees, fixed assets, cost of capital, income, expenses, initial inventories, fixed assets and their increases, etc.) are established. The third step is to calculate a financing rate (the cost of capital) and estimate income and expenses over an extended period (5 years). The fourth step is to apply various capital budgeting techniques to arrive at an accept or reject decision.
So, we start with an investment program in which what is necessary for the implementation is established, with amounts, purchase values, useful life (estimated duration of a good), salvage values (value of the asset that is not depreciated, At the end of the useful life of the asset, we have that residual value without depreciation) and value to depreciate (decrease in the value of an asset), in this way we will have our initial investment. Another concept that must be taken into account at the beginning is the working capital, which is the investment that is needed to carry out the economic and financial management in the short term, understanding the short-term periods of time less than one year.
If the project involves the sale of products or services, it is highly recommended to carry out a market study to estimate potential annual sales and their annual growth rates. It is also necessary to calculate the price of our products or services and its annual increase (considering inflation). In this way we can estimate the annual income considering the annual increase in sales and price.
Subsequently, all the costs for the operation of the project must be calculated, the costs can be:
Variables: they change in proportion to the activity of a company such as labor, raw materials and energy, these costs also change as a result of the estimated sales increases for each year and due to inflation.
Fixed: they remain unchanged before slight changes in the activities of a company such as salaries or administrative materials.
It is also necessary to remember that costs are updated according to the inflation or growth rate of the company.
To cover the initial investment or part of it, investors or financing with defined settlement rates and times are usually used. Therefore, each investor, to make the decision to undertake or not in the project in question, must bear in mind the risk premium and discount rate, concepts that are explained below.
When faced with an investment decision, an investor can choose between two types of assets: one with risk or one without risk. Since one asset is risk-free and the other asset has risk, then the difference in the return of the two assets will be the risk premium. In short, it is a prize that the market grants to the investor for assuming risk with respect to the risk-free asset. Formally, public debt in the macroeconomy is considered a risk-free asset.
Perhaps one of the most widely used and widespread methods to calculate the risk premium is the use of the CAPM (Capital Assets Pricing Model) model, in which the return on the asset with risk (in this case the return that each investor, or sources of financing, waiting for the evaluated project) is the result of adding the profitability of the risk-free asset and the risk premium. So the latter is equal to the return on the asset with risk minus the return on the asset without risk. The riskiest investments must be required to have a higher return.
The cost of equity or discount rate is made up of the rates of return required by investors plus the cost of borrowing money. Then, once the risk premium has been estimated, the discount rate can be calculated by adding the weighting of the minimum rates of return acceptable to the investor (s) and the interest rates of the financing.
Investment evaluation
There are several methods for evaluating investments (Saxena, 2015): discounted cash flow (DCF), net present value (NPV), internal rate of return (IRR), payback period, and profitability ratio.
-Discounted cash flow helps to calculate the returns that would be obtained on the investments and how long it would take to recover them. It is recommended to estimate the cash flows for initial costs, income and expenses for the first five years. It is also necessary to calculate after-tax cash flows, these include annual income, annual expenses, depreciation and taxes, interest expenses are not included. Ending cash flow includes all one-time cash flows that occur at closing and could include after-tax salvage value, restoration expenses, sale of business income, etc. These cash flows occur in the fifth year and must be offset against the after-tax cash flows.
-Net present value is the main tool used in discounted cash flow. The NPV is the present value of the cash inflows less the present value of the cash outflows and provides the estimate of the change in the value of the business. The business is acceptable if the NPV is positive.
-The payback period indicates the number of years required to recover the initial investment, but it does not take into account the current value of money, it is an imprecise method and financially I consider it a lax evaluation method since it depends on the criteria and of the patience of the investor.
- The profitability ratio is the present value of the cash inflows divided by the present value of the cash outflows and provides the return for each unit invested. The business is acceptable if the profitability index is greater than one.
- The internal rate of return (IRR) is the discount rate that equals the present value of future cash flows with the initial outlay. Provides the percentage return on invested funds assuming that cash flows are reinvested at the internal rate of return as they enter the business. If these funds cannot be reinvested at that rate, the return will not be achieved. For this reason, the IRR can sometimes be too optimistic. The IRR must be greater than the company's cost of capital for the project to be profitable.
Which one to apply?
As an interesting fact, there are studies that suggest that culture exerts considerable influence on the reasoning of decisions (Shu-Hui et al., 2018), this could be a factor causing variability in the application of capital budgeting techniques. But some also claim that economic, political, legal and social uncertainty impact on the use of capital budgeting systems (Graham and Sathye, 2017), with higher levels of uncertainty more sophisticated systems are used. At the same time, others indicate that large companies tend to rely on discounted flow analysis, while small companies evaluate projects using the payback period or by instinct of the owner (Danielson and Scott, 2014). Opinions are different,But in the end, the choice to trust one method or the other depends on the perception and objective of the interested investor.
Limitations observed in traditional financial evaluation methods.
Although the Net Present Value (NPV) and the Internal Rate of Return (IRR) are widely used by CFOs, they have received numerous criticisms.
First, the assumption that the sole objective of investment analysis is the maximization of business value is questioned. In this sense, Steuer and Na (2003) affirm that modern companies do not exclusively seek to maximize shareholder wealth, but rather consider the balanced achievement of a set of objectives related to the interests of all the company's stakeholders (shareholders, managers, workers, suppliers, customers,…).
Second, several authors affirm that quantifying the value of a company not only implies considering tangible assets of a monetary nature, but also all those of an intangible and non-monetary nature, which are not accounted for and, therefore, are not reflected in the statements. financial For example, the knowledge and skills of company personnel, knowledge of production processes, or customer satisfaction and loyalty. On the other hand, the concept of intellectual capital has been developing in recent decades. Stewart (1997) defines intellectual capital as “the sum of all intangible elements that contribute to generating competitive advantage”. Intellectual capital is classified as: human capital (Know-how, entrepreneurial spirit, employee satisfaction),structural capital (corporate culture, organizational structure, organizational learning) and relational capital (relationship with suppliers and the environment) (Subramaniam and Snell, 2004).
It is complex to include and evaluate the environment and sustainability in traditional evaluation methods, for this multi-criteria analysis techniques are proposed, to help capture these difficult aspects to qualify (Schaltegger et al. 2006), the latter require engineers, sustainability administrators and much more staff outside the financial and accounting domain. Obviously including these aspects would make the analysis very complex, it could even exclude small and medium-sized companies, and for large companies it would require a greater commitment from those involved.
To conclude, we know that classical valuation techniques have difficulty recognizing the real value generated with an investment, since in practice they ignore important variables and qualitative impacts that also generate business value, an example is intellectual capital, which is an important source of competitive advantage in the company, because as we know intangible assets are difficult to reproduce and imitate by the competition and have a direct impact on innovation. Planning and making decisions about projects taking into account environmental impact aspects would be ideal since companies that carry out environmental management improve their image and make it possible to increase the price of organic products or cover certain market niches, not to mention its positive social impact.The question here is: How effective are traditional accounting designs in capturing attributes related to sustainability? It is very complex to include sustainability aspects in investment evaluations, even in the presence of uncertainty, it is difficult to adjust numbers to achieve that a project can be profitable, some proposals to include these aspects could be using techniques such as complete social accounting and environmental cost, analysis life cycle, cost-benefit analysis and sensitivity analysis. Obviously, tangible benefits are a priority for investors, but it is up to the government to incentivize or motivate financial decision-making with a sustainable approach.Thus, companies would not be exclusively concerned with the efficient allocation of capital but also with the efficient allocation of environmental and social resources.
Bibliography
Steuer, RE, and Na, P. (2003). Multiple criteria making decision combined with finance: A categorized bibliographic study. European Journal of operational research, 150 (3), 496-515.
Saxena, AK (2015). Capital budgeting principles: bridging theory and practice. Academy Of Accounting & Financial Studies Journal, 19 (3), 283-293.
Shu-Hui, S., Hsiu-Ling, L., Jung-Ju, C., Jen-Yin, Y., and Minh Hang Vu, T. (2018). Application and effects of capital budgeting among the manufacturing companies in Vietnam. International Journal Of Organizational Innovation, 10 (4), 111-120.
Graham, PJ, and Sathye, M. (2017). Does National Culture Impact Capital Budgeting Systems ?. Australasian Accounting Business & Finance Journal, 11 (2), 43-60.
Danielson, MG, and Scott, JA (2006). The capital budgeting decisions of small businesses. Journal of Applied Finance, 16 (2), 45.
Stewart, TA (1997). Intellectual capital. Rio de Janeiro: Campus, 29.
Youndt, MA, Subramaniam, M., and Snell, SA (2004). Intellectual capital profiles: An examination of investments and returns. Journal of Management studies, 41 (2), 335-361.
Schaltegger, S., and Wagner, M. (2006). Integrative management of sustainability performance, measurement and reporting. International Journal of Accounting, Auditing and Performance Evaluation, 3 (1), 1-19.
