Being a freelance designer is just too tempting. You finished university, you are fed up with the office where you have been working for a couple of years or you were dissatisfied with your internship as a Jr. designer and you decide to start your own agency.
At first, your workload is not a challenge that you cannot overcome with your computer, a printer at home, basic tools and your indispensable suppliers; But as you grow and the complexity of your projects and the needs of your customers increase, you think how well you would like a workshop, a more powerful computer or a printer with better functions. However, realizing these wishes can get a bit frustrating when you think about money and how difficult it would be to invest your limited savings.
Imagine that you finally decide to save money to buy a new computer or why not? Build a small workshop with more advanced machinery that would allow you to have more clients and deliver projects with higher quality; Questions like How much do I have to save? Is the computer or the workshop better for me? Should I process a loan? How much money am I going to owe the bank? If you asked yourself all these questions… or not, you are in the right place to learn how to answer them and make better decisions for your business.
Next, I will explain the bases to create your own capital budget. They are basically a series of steps that allow you to evaluate and select long-term investments that are consistent with the objective of maximizing the wealth of the owners of the company (Gitman J. and Zutter J. 2012). or to generate market value that does not necessarily increase your pocket, but your value as a company. (Guerrero-Baena, MD, Gómez-Limón, JA, & Fruet Cardozo, JV, 2013).
To start we have to know some basic financial terminology. It is very normal to have to evaluate two projects at the same time, if your funds are limited and you cannot pay for both at the same time, a situation known as capital rationing. In this case you would have to do an evaluation of mutually exclusive projects, where the project with the highest performance wins. You could be lucky and have unlimited funds, either thanks to your ability to acquire loans or being in the care of a risky investor; in this case you can allow yourself to do an evaluation of independent projects and you can accept any that leaves you good profits.
To explain the three most basic techniques for making your capital budget, I will use a design example to make everything much more familiar:
Your student licenses for Program A (design software for 3D modeling and rendering) have expired and you can no longer access school computers to use Program B (rendering program). As part of your operation as a designer is to deliver photorealistic renders * to your clients, you need one of the two programs. You know that with Program A you can get incredible results, but it requires too much processing time and that, on the other hand, Program B gives you excellent results in much less time. In which of the two would you invest? In the image Cash Flows_1 I show the cash flows, that is, the inflows and outflows of money that each program implies.
Cash flows
An easy way to visualize the flow of money for any project is to place a horizontal line and divide it into the number of periods your project will last. Take into account that the first period or period 0, is when you make the disbursement of your money, that is, you lose it; that's why I put it in negative and with a down arrow. When it is a profit I put an arrow up pointing the money obtained. In the example I connect all the arrows with another horizontal line to indicate that in each period I get the same amount of money.
The first thing you want to know is when you are going to get the money you just paid back. The time it takes you to fully recover your money is called the payback period and, although it can be considered a rudimentary method to evaluate an investment because it does not take into account the value of money in time (that is, it ignores that $ 1.00 today won't be worth the same in 5 years) is a method used by small businesses to make quick decisions.
To calculate the Recovery Period of normal flows, that is, flows that do not change from period to period, simply divide the initial investment by the value of the flow. With programs A and B, the recovery period is very short, by making the corresponding divisions we obtain the following results:
Investment Recovery
The closer to 0 the result is, the faster you will recover your money, in this case, we would recover almost half of the first month the investment made to buy Program A, unlike Program B for whose investment it would take three-quarters of the first month. If our selection were independent projects, both are quite convenient; But since our selection is mutually exclusive, the best option is Program A.
The objective of making a capital budget is to be certain of a decision, so a single tool would not be enough. Not very convinced of the result of the payback period, you would like to know how much money you will have in a year if you invest today in one of the two programs. The technique of Net Present Value, VPN for its acronym in Spanish, allows you to know the value of your money subjected to the passage of time and the inflation rate.
The NPV takes the cash inflows, transforms them to their present value, and adds them up; The initial investment will be added to the resulting value. The interesting thing about this method is that each cash inflow deducts it at the rate you use. At the time of writing this publication, the inflation rate of Mexico according to the Bank of Mexico, is 4.65% ± 1; I will conservatively consider it 5.65% which rounds up to 6%.
In a spreadsheet you can enter the formula = NPV (Net Present Value), select the discount rate (6%) and then the flows other than the initial investment, at the end you will add the initial investment. Applying this method to the example of the programs gives us the following values:
VPN
If you invested in Program B today, you would have much more money in your hands than if you invested in Program A. This evaluation conflicts with the payback period, since, unlike the first evaluation instrument, the most convenient project is the B.
The way to evaluate projects with the NPV is to consider that if the value obtained is greater than 0 it is accepted; if it is less, it is rejected. As they are mutually exclusive and the two values greater than zero, we are going to classify them and choose the highest one.
Remember that the more tools you have to make the decision, the more certain you have about which is the best project. Therefore, I will explain one more method, the Internal Rate of Return or Return, TIR for its acronym in Spanish. It is a method that consists of comparing the NPV with 0%, since it is as if the sum of the present value of the cash flows were equal to 0. Practically, it is the rate of return that the company will have if it invests in a certain project (Gitman J. and Zutter J. 2012).
In a spreadsheet you can use the instrument by inserting = IRR or = IRR (Internal Rate of Return), selecting all the cash flows, including the initial investment. Thus we obtain the rate that we would receive when investing in either of the two projects.
IRR
According to the IRR, the most convenient project is, again, A. This rate obviously changes depending on the project and its selection reason depends on the following reason:
The IRR is greater than the cost of capital, so it is accepted; if it is less, it is rejected. The cost of capital is the rate of return that the company must obtain on its investments so that its market value remains unchanged (Gómez G, 2001). In this case, suppose that if no program convinces you, you can invest in CETES to obtain a return rate of 7.74% indicated by Banco de México; As the IRR of the two programs is much higher than 7.74% of the CETES, investing in either of the two is a better option than not doing it.
It may be that you are now more confused than at the beginning, since the VPN tells you that you would have more money in your hands and the Internal Rate of return says, apparently, the opposite.
In this case, you will have to do the analysis of this conflicting classification of projects, whose understanding is quite simple. If you remember that the initial investment for Program A is $ 19,941.41 and that for Program B it is $ 37,680.16, you will realize that it is much more convenient to receive 133% of the initial investment of project B than 188% of program A.
The best option is Program B. Although in two of the instruments we have found Program A more attractive, when comparing the results of each instrument you will understand that Program B leaves you more profit, despite the high initial investment.
Sometimes the classifications correspond, in such a way that the NPV and the IRR are favorable to the best project, but it may be that the different reinvestment rates, the magnitudes and times of the cash flows generate conflicts as we saw in the example. Therefore, it is recommended to always use the two methods simultaneously for better decision making.
Now your business as an independent designer can select investment projects with greater certainty, always sure that you are selecting the option that best aligns with your growth and resource maximization objectives. You already have the bases to start evaluating the options that are presented to you, I invite you to continue looking for more sophisticated ways to verify that you are taking the next step on the right foot and that, as a designer, you make sure you have solid financial foundations to be successful as an entrepreneur.
References:
Gitman J., Lawrence, and Chad Zutter J. Principles of Financial Management. Mexico: Pearson Education, 2012.
Gómez, G.. (2001). Capital cost and its effects on investment. June 21, 2018, from Gestiópolis Website:
Guerrero-Baena, MD, Gómez-Limón, JA, & Fruet Cardozo, JV (2013). The valuation of productive investments: A methodological approach based on the creation of financial and intellectual value. Intangible Capital, 9 (4), 1145-1169.
