4.4 Capital requirement calculation

Investing means investing capital for a specific purpose. The term "investment" (Latin: investire = to clothe) means the "clothing" of the enterprise with assets for the purpose of enabling the performance process within the enterprise. Investing is thus a core function of all economic activity.

The investment can be interpreted as a disbursement for the procurement of goods, the utilisation of which is expected to generate cash inflows that (significantly) exceed the disbursements in the long run. The success of investments is uncertain. Whether an investment is advantageous from the perspective of an entrepreneur depends on his expectations of profit and return as well as his willingness to take risks.

Investments are made in fixed assets such as land, buildings, machinery, financial investments on the capital market, research and development, as well as in acquisitions that are used for the longer term to fulfil operational purposes, e.g. trade fair stands for advertising, marketing concepts, licences or rights.

Any disbursement that is associated with the expectation of generating future cash inflows can be described as an investment. However, such a broad term for investments is only of limited use. Therefore, only those disbursements that result in longer-term utilisation potentials or asset positions, such as acquisitions or investments on the capital market, should be described as investments.

Investments must be economical. The amount of capital must be fixed in such a way that it is economical in the long run, i.e. it yields more return than it costs.

Justify investments

• Why is an investment necessary? 
• What equipment, plant, machinery or facilities does the company need? The quality and the customer benefit are to be determined.
• Which equipment, etc. is the cheapest for the company?
• How should the equipment, etc. be utilised? The degree of utilisation is to be determined, capacity planning is to be carried out.
• At what time is the equipment needed?

How can the necessary capital for the investment be raised on time?

 

Types of investment

Investments can be distinguished:

Performance readiness investments: new investments when starting or expanding a business, replacement investments when machinery is lost or worn out.

Investment in tangible assets: Creation or modification of material performance potential in fixed assets (e.g. purchase of machinery) or in current assets (e.g. stock replenishment). According to the investment motive, they are further subdivided into construction, expansion, rationalisation, conversion, diversification, safeguarding and replacement investments.

Intangible investments: Creating or changing intangible performance potential (e.g. capital commitments for patents, licences, product research, process research, personnel development, organisational development, marketing).

Financial investments create capital commitments with which participation or claim rights are acquired, either in order to generate the highest possible return with a defined risk or in order to draw benefit from the financed company, e.g. by influencing its business policy or to secure a cooperation.

Economic efficiency of investments

When planning investments, economic efficiency must be examined. The focus is on the capacity and utilisation of the investment. The necessary capacities must be determined for a company. Capacity is understood to be the performance capacity of an enterprise within a certain period of time, measured in terms of production or output. It depends on the plant and machinery, the company organisation and the employees.

The type and amount of investment must be adapted to the operational requirements. The question is, what capacities are needed? 

• The maximum capacity (maximum capacity) indicates what a farm is capable of achieving. The maximum capacity cannot last in the long run if it is not expanded.
• The normal capacity indicates what the farm is capable of achieving in the long run at full capacity. It is therefore lower than the maximum capacity.
• The minimum capacity refers to the utilisation at the lower limit that is necessary in order to still be able to carry out the production or service at all.

Time

The timing of an investment must be determined according to economic considerations. The financing of an investment must be made on time. This means that at the time of acquisition and payment, the liquidity for it must be established.

In the case of start-ups, a distinction must be made between the time of acquisition before and after the start-up.

• Investments that have to be paid for before the foundation can be considered foundation investments, those afterwards are new or replacement investments. 
• The sum of the start-up investments can be written off in the business plan as upfront costs. This must be taken into account in the liquidity calculation.
• Investments made after the foundation of a start-up or in an existing business must be capitalised at the time of payment. This means the cash flow has an impact on the liquidity statement and the income statement. From the time of payment, depreciation is to be taken into account in the P&L with the corresponding depreciation rates.

 

Investment calculation

Investment has been defined as the acquisition of an economic good to be used in the long term. Investment is characterised by the fact that capital is used in the present in order to gain an advantage in the future. This is an expression of entrepreneurial action.

The investment process begins with the mental anticipation of an asset to be procured. Investment planning is oriented towards the company's investment goals and is the first stage, which is followed by investment implementation and control. Investment plans have a prominent role because they are used to decide whether and in which business area new projects can be organised. Investments must create the resources to realise the company's goals. 

The investment decision is of strategic importance. If institutions did not invest, they would sooner or later become so obsolete that they would no longer be able to carry out their business activities. Investment appraisal can assist in the decision-making process:

Case study: Investment calculation of an EDP system

Investments are based on a large number of forecasts. This can be clearly illustrated by the model of payment sequences: Payments and receipts are linked to each other during the useful life (Grob 1994, p 956 ff):

 

Payments

 

The liquidation value indicates the proceeds that would ultimately be realised if the IT system were sold. The sale price can be considerably lower than the book value.

Sample data:

The investment object (IT system) can be procured at a price of € 75,000. The payment is due in t = 0. It is paid from the existing bank balance (equity capital). At this point the asset is fully operational. In the investment calculation, a useful life of 5 years is planned. During this period, constant payments of € 13,500 per year are made for the maintenance of the system.

The facility should be able to train a maximum of 300 participants per year. Because the facility has the latest user programmes, the utilisation rate after the start-up phase is higher in the first three years than in the last two years. The projected development of demand could be as follows:

 

Year	t =1	t=2	t=3	t=4	t=5
Demand/participants	210	285	295	195	185

                                               

The participant-related costs should be set at an average of 200 € for materials, energy consumption, fees. They are expected to increase by 10 € per year.

The participant fee is to be € 310 per course. For further development, an annual increase of 10 € from the price of the previous year is to be assumed.

At the end of the five years, a liquidation surplus of € 7,500 should arise because the plant can be used further. All costs and revenues should result in payments out and payments in, respectively, in the same year. The payment sequence of the investment has been calculated using the above data with an Excel programme as follows (figures have been rounded for simplicity).

 

Example calculation:

Time lapse in the year	t=0	t=1	t=2	t=3	t=4	t=5	Total
Acquisition payout	75.000 €
Capacity		300	300	300	300	300
planned participants		210	285	295	195	185
Participant fee		310 €	320 €	330 €	340 €	350 €
Sales revenue = Payments received		65.100 €	91.200 €	97.350 €	66.300 €	64.750 €	384.700€
variable TN costs		200 €	210 €	220 €	230 €	240 €
variabl. Disbursements		42.000 €	59.850 €	64.900 €	44.850 €	44.400 €	256.000 €
fixed costs = disbursements		13.500 €	13.500 €	13.500 €	13.500 €	13.500 €	67.500 €
Liquidation surplus						7.500 €	7.500 €
Payment sequence of the investment		9.600 €	17.850 €	18.950 €	7.950 €	14.350 €	68.700 €

Table 24: Example investment calculation

With the investment, a total turnover of € 384,700 could be achieved in five years. The surplus would be € 68,700 after deduction of the calculated costs and plus the liquidation surplus. That would be a 17.8 percent return.

If the capital of € 75,000 were invested with a bank at an interest rate of 3.5 %, the interest would be € 13,125 in five years. The investment shows a much better result.

Of course, the financial reality in business is more complex. Especially when the investment capital has to be borrowed from a bank. As borrowed capital, it must be serviced from current income. Taxes and duties are also incurred. Such a further consideration can initially be neglected in a business plan.