Relationship between assertive capital planning and surviving in the market

On several occasions, concrete data on the importance of SMEs in Mexico has been presented, it has even been shown that 99.8% of them correspond to 52% of the national GDP and 72% of employment in the country. However, despite the relevance that the role of small and medium-sized companies take within the country's economy, according to the Organization for Economic Cooperation and Development (OECD) the growth of SMEs by just 41% in the The last six-year term was relatively low considering that of other member countries with a 50 to 60 percent growth in the same period (Hernandez, 2018).

Until a decade ago, 7 out of 10 companies did not survive the first two years of birth. After some support generated for entrepreneurs, the mortality of SMEs has decreased to 5 out of 10 companies that fail to survive the first years of life.

The absence of a financial and business culture is on many occasions the reason for failure for entrepreneurs in this country. Despite the efforts of the government and other private institutions to support the social initiative of the population by being economically independent, the lack of a well-established base from the beginning of life of small and medium-sized enterprises is what reduces their permanence in the current market.

Which brings us to the next question, how can the financial stability of a new company be maintained beyond the first two years of life? There may be various options to resolve this situation, however this time we will focus on the well-known “capital budget”. Even through the following pages we will develop in a clear and simple way so that any future entrepreneur can have a better perception of the key financial elements that must be evaluated before undertaking a new project.

What is the famous capital budget?

Before embarking on a long-term investment project related to fixed assets, that is, all those productive assets that will bring a benefit through land, plant and equipment with the capacity to generate a good or service, it is essential to financially evaluate all the possible options that may lead to a successful or unfortunate decision making.

The capital budget is nothing more than the appropriate way to carry out an analysis of any long-term investment in productive assets and evaluate that these are congruent with the goals of maximizing resources of any company or future company.

Returning to the unconvincing performance of SMEs in the last six years, the importance of carrying out a capital budget is maximized, since, if carried out incorrectly, the return on investment, a form of financing among other key elements before starting any long-term project could be the cause of death during the first years of the company's life.

The path for the elaboration of said budget is guided by five processes according to Gitman and Zutter (2012), which are summarized as follows:

Preparation of proposals: These proposals must be reviewed in detail by the financial area of any company Review and analysis: It is necessary to consider all possible options and analyze the impact that each of them will have on the financial aspect of the entity. Decision: Once the investment options have been analyzed and evaluated, it is the task of the direction or management to choose the best of them.Implementation: Any investment requires an outlay of money, the larger the amount necessary it is common to see that this process occurs in more than one phase so as not to affect the cash flow of the company.Follow-up: This process usually helps entrepreneurs to compare what is budgeted with what is real,since with this comparison the investment is qualified and decisions can be made about new projects or improvements to it.

Through these five steps, every entrepreneur will be able to guide the elaboration of an efficient capital budget that really meets the objectives and initial reason for being. However, there are also some tools that are essential in the said budget that satisfy the basic financial requirements that every investment should consider to guarantee good results.

How to know if an investment will bring benefits?

As mentioned at the beginning, the objective of this article seeks to support future entrepreneurs to evaluate an investment before executing it and in this way to ensure that SMEs survive the first years of life, since unfortunately sometimes entrepreneurs they do not consider the financial part in their projects.

There are two types of projects, independent projects and mutually exclusive projects. Independent projects are understood to be those whose cash flows are not related to each other, since the approval of one project does not prevent the others from continuing to be taken into account. Unlike mutually exclusive projects that share the same goal, therefore, they compete with each other.

Within project evaluation there are different types of approaches to determine whether the investment is accepted or not. The acceptance-rejection approach is the most important of all because, when evaluating capital investment proposals, it must be determined whether they meet the minimum criteria for acceptance by the company. When a project is accepted it must be compared against the minimum expected rate of return. It is important to consider that to accept a project, the investment recovery period must be taken into account, since it is the time required for the company to obtain back the original disbursement of its initial investment, calculated from the income of cash.

When companies make investments, they spend the money they get in one way or another. Investors expect a return on the money they bring to the business, so a company should make an investment only if the present value of the cash flow generated by the investment exceeds the cost of the investment made in the first place.

There is a tool that companies should use to evaluate the cash flows obtained through an investment. In other words, the NPV (Net Present Value) method takes into account the value of money of investors over time, this is a key tool in capital budgeting.

When the NPV is used to make accept or reject decisions, the decision criteria should be as follows:

If the NPV is greater than $ 0, the project is accepted. If the NPV is less than $ 0, the project is rejected. If the NPV is greater than $ 0, the company will earn a return greater than its cost of capital.

This action aims to increase the market value of the company and, consequently, the wealth of its owners by an amount equal to the NPV.

There are three main reasons why the NPV is usually the best option to calculate the value of a project:

The NPV method assumes that project cash flows are reinvested at the rate of return required by the company since the IRR is higher than the required rate of return.The NPV calculates the value of the project more directly than the IRR because the NPV actually calculates the value of the project Over the life of a project, cash flows must be reinvested to cover depreciation.

Investment Return Rate), is the discount rate that equals the Net Present Value of an investment opportunity. The present value of the cash inflows should be considered equal to the initial investment. The rate of return is that which the company will earn if it invests in the project by receiving the expected cash inflows.

When IRR is used to make accept or reject decisions, the decision criteria are as follows:

If the IRR is greater than the cost of capital, the project is accepted. If the IRR is less than the cost of capital, the project is rejected.

On the other hand, the Internal Rate of Return must be considered, with this it is intended to use a single rate or performance of the project since it is based solely on the project's cash flows and not on external rates. For this, the following points should be considered

When an investment is made, it must be taken into account that, if the IRR exceeds the required yield, otherwise the project must be rejected.The IRR is the yield required so that the calculation of the NPV with that rate is equal to zero. there is a mathematical approach to calculating the IRR. The only way to find it is by trial and error.

Example

If we had an investment project in which a new product of leather bags with unique designs is going to enter the market. The flows we project for this product are $ 20,000 in the first year, $ 40,000 for the next two years, and $ 10,000 for the fourth year.

In order to start this project, an initial investment of $ 50,000 will be needed and the brand requires a 10% return, every two years the designs will be renewed according to fashion trends.

For this exercise we can solve it in the following way

NPV = - 50,000 + (20,000 / 1.10) + (40,000 / 1,102) + (40,000 / 1,103) + (10,000 / 1,104) NPV = - 50,000 + 18,181.8 + 33,057.9 + 30,052.6 + 6,830.1 NPV = $ 38,122.4

With this result we can say that according to the statistics that were proposed in said project, the NPV of the Project is positive, therefore, with greater security, it is possible to invest in the project.

conclusion

We can conclude that the capital budget is a tool that supports entrepreneurs to evaluate their investment projects in productive assets and provides necessary financial information to those who must make decisions. We were able to identify that a capital investment is a disbursement of funds that is made at the time of accepting a project, from which it is expected that long-term benefits will be generated.

Before accepting any project, it is important to verify that the proposals they are making are well prepared, this will facilitate the review by the finance staff. When financial managers conduct reviews and analysis, they will evaluate the benefits of investment proposals so that when making the decision they delegate about capital investments according to money limits. After the project is authorized, the disbursements are made to be able to implement the project and finally it is important to monitor the results so that the real costs benefits are compared with those previously planned.

With the tools exposed throughout this article, future entrepreneurs will be able to have a better scope of financial evaluation required before undertaking a new project or making any long-term investment.

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