Capital budgeting is the process of planning and managing the company’s long-term investments.

The elaboration of a capital budget requires several concepts that are related to each other. So we are going to clarify in a general way some definitions which the reader can deepen. The main thing is that you get a clear and brief idea of ​​how to prepare a capital budget. This tool is very useful for making decisions about an investment project.

Table of Contents

Introduction 

Sometimes the need arises to carry out an investment project to increase the capital. For this, the financial manager needs to evaluate the project to determine if the project is profitable or not. That is if the money flows show enough profit for the project to exceed costs and be sustainable over some time.

The objective of this work is to explain concepts in a general way to prepare the capital budget.

But what is a capital budget?

According to Gómez S. (2015), “The capital budget is the process of planning and managing the company’s long-term investments . Through this process, the organization’s managers try to identify, develop and evaluate investment opportunities that can be profitable for the company. It can be said, in a very general way, that this evaluation is made by checking whether the cash flows that the investment in an asset will generate exceed the flows that are required to carry out said project”.

To carry out the evaluation, it is necessary to be clear about the concepts that are required to prepare the capital budget. In general, it is necessary to collect the basic data of the investment project, such as the cost of the initial investment, estimated income, variable costs, fixed costs, and financing data.

Finally, in the elaboration of a capital budget, the financial evaluation will be explained, which consists of valuing the money flows against the indicator of net present value or the IRR.

The initial investment in the capital budget

The initial investment is understood to be the disbursement of the person or company that is required to start a project, without taking future expenses into account. In this aspect, the costs of the fixed assets to be acquired, the working capital, the salvage value, and depreciation must be considered.

Fixed assets are goods that are acquired to create a product or service, such as buildings, machinery, land, plant, and equipment. All assets have a salvage value, which at the end of the project can be sold at a lower price than they were purchased.

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Also, some of the fixed assets may have depreciation or loss of value. Depreciation is a financial calculation that gives the benefit of declaring an additional expense to reduce the amount of taxes payable.

The working capital will be the amount of money necessary to support the variable costs in case there are no sales. In other words, it is the minimum short-term investment to trade, or it can be seen as the initial balance of the bank account. This amount can be estimated according to the estimated level of sales. For example, the project is expected to have no sales in the first two months, so you would need to calculate how much money would be needed to cover variable costs.

Estimated income.

The financial manager must estimate how many units will be sold each year and at what price. This will determine the estimated sales for the project. For this, the prices must consider the percentage of inflation for the following years.

Variable estimated costs.

According to Riquelme M. from webyempresas.com, variable costs are those expenses that vary in proportion to the activity of the company. Variable cost is the sum of all marginal costs per unit produced. In this way, fixed costs and variable costs constitute the total cost. They are often referred to as unit-level costs produced since they vary according to the number of units produced.

It can be said that they are the costs associated with production. The costs vary according to the volume of sales. For example, raw materials, labor, energy, and fuels.

Fixed costs and expenses in the capital budget.

To define this item of the capital budget, Riquelme M. from webyempresas.com also mentions that fixed costs are those business activity expenses that do not depend on the level of production. Management often refers to them as “overheads.”. They are not fixed permanently, as they tend to change over time, but this change will not depend on the amount produced for the period in question, therefore, these make up those costs that the company must pay regardless of its level. of operation, that is, whether it produces or not, it must comply with these payments. Conceptually, a fixed cost is an outlay in the company compulsorily incurs, even when it operates at half speed, or in the worst case, it does not operate for some reason of force majeure. For this reason, they constitute a serious problem for companies, especially when, for some reason, their productivity and income decrease.

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They are costs that are independent of the production that, even if there are no sales, would have to be paid. For example, administrative salaries. They also include administration expenses such as telephone, internet, rent, and fuel.

Financing data.

To fix this data in the capital budget of the investment project, it is necessary to define where the money will be obtained to finance the project. The owners of the business could put up their own money to invest it. In this way, they would remain as shareholders and the decision-making level would depend on the percentage of contribution. Another option is to obtain a bank loan where the bank defines a discount rate that it requires from the project to ensure that the credit can be paid. This discount rate is the minimum percentage that the project must contribute as a profit.

“The concept underlying this definition is that if I have €1,000 today and I leave it in a drawer, when at any future time I take that money and want to buy products and services, I will be able to buy fewer products than if I had spent them today. ”. Vincent Esteve (2017).

The rate must consider the risk-free rate, for example, Cetes, plus a premium percentage for risking the money. Usually, this rate is called Trema (minimum acceptable rate of return).

The Federal Treasury Certificates (FTC) are the oldest stock market debt instrument issued by the Federal Government (Bank of Mexico (1999).

Financial evaluation of the investment project.

To evaluate the project and its capital budget, the following steps are followed:

In the first step, you need to calculate the profits per year, both nominal flows and discounted flows. The nominal flows are the amounts that the project will give as profit in the future. However, these flows will have a lower value in the future due to inflation, so discounted flows need to be calculated. Each amount in the future needs to be brought to the present using the present or present value (PV) formula. Once the discounted flows are obtained, they are added and the value of the initial investment is subtracted, resulting in the net present value (NPV). If the net present value is greater than zero, the project is accepted, otherwise, it is rejected. There is also another way to evaluate the project, using the IRR. The IRR is the minimum rate where the net present value is equal to zero.

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In addition, it is important to obtain the break-even point, which is the level of sales required to cover fixed costs and variable costs. For this, all the fixed costs can be added and divided by the marginal profit percentage, which is the utility obtained by discounting the variable cost. The advantage of the breakeven point is that it can help set sales targets.

Finally, it is necessary to make a bank credit amortization table where it shows the initial balance, the interest payment, the capital payment, and the final balance for the duration of the project. The purpose of this is to control money flows until the debt is settled.

Investment strategy.

One of the strategies in the investment project is to seek to reduce the initial investment so that the project is more profitable, that is, to disburse less money at the beginning. You can also look for a bank to charge a lower interest rate on the credit.

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