Another aspect of estimating future cash flows is that the information must be provided on an incremental basis so that the difference between your cash flows may be analyzed with and without the project. This is important in that, if you are contemplating a new product that is likely to compete with existing products, it is not appropriate to express cash flows in terms of estimated sales of the new product without consideration of the effect the new product may have on existing products. You must consider that there probably will be some cannibalization of existing products. Another assumption often made is that the risk or quality of all investment proposals under consideration is the same as the risk of existing investment projects. Therefore, the acceptance of any proposal or group of investment proposals does not change the relative business risk of the firm. This is not necessarily true; each proposal should be looked at individually relative to its riskiness.
Ordinarily, after-tax cash flows are used for capital budgeting calculations. Usually depreciation at the maximum allowable method is used for tax purposes. Remember, however, that if depreciation is subtracted other than for calculating taxable income, you are double counting. This occurs because you have already “expensed” (treated the cost as a cash outflow) the investment in year zero. The only reason for being interested in depreciation is for the calculation of expected tax.
The internal rate of return cannot be used for making a decision to lease or purchase a piece of equipment, because a true lease requires no investment. The rate of return, therefore, would be infinite. It is, however, often more profitable to buy. Leasing usually is done because of a lack of or an attempt to conserve cash. It is a method of financing and therefore is a part of the second-stage financing decision mentioned at the beginning of this chapter.
Interest costs on borrowed money should not be included in the calculation of cash flows because the method of financing should not determine the decision as to whether the project is a good deal. Besides, the cash flows will be multiplied by the discount rate, which already includes interest as part of the cost of capital considerations.
Uncertainty should be included in the discount rate. When trying to quantify uncertainty, you should question the sources of the information:
How old is the information? and How reliable is the information?
Always search for alternative sources of information. There is rarely only one way to accomplish a project. Find other methods and evaluate them. Be suspicious if it appears there is only one way to do the project. Your people may be reluctant to consider alternatives. Ask such questions as:
Are there less expensive ways? Are there less risky ways? Are there ways that retain more options?
One of the often-overlooked uses of the capital budgeting process is for the determination of product discontinuance. In a highly diversified business, in which large numbers of similar or related products are manufactured, reevaluation of existing product lines should be undertaken on a regular basis using capital budgeting techniques. This is useful to determine whether existing products are optimally utilizing the company’s resources.
Checklist of Data
A 10-step checklist of the data required to make a decision about maintaining or eliminating a product follows.
- An estimate of the variable expenses directly applicable to the production of specific products, including the costs of production and marketing
- An indication of the number of units of the product sold during past periods, net of sales returns
- Total sales revenues generated by each product within each time period
- Estimates of sales revenues for competitive products and the price per unit, units sold, and market share of each competitor
- Current and past pricing structures for all products including price discount policies and the distribution of order quantities
- Inventory turnover ratio for each period of time
- A projection of future sales for each product carried
- Estimation of the total overhead costs devoted to each product
- The trend line of product returns and warranty claims
- Forecasted changes in the cost of components required to build each product
This checklist can be used to detect whether a product needs help or should be considered for elimination. The discontinuation of products can result in increased profits through the elimination of marginally profitable or high-cost products and by reducing Over diversification in a business’s product mix. Elimination of over diversification can increase production and marketing efficiencies by concentrating your efforts and resource utilization.
It should be noted, however, that the indications of candidacy for elimination of a product is not simply a go/no-go test established from quantification of the checklist items. Sometimes healthy products should be eliminated if an analysis shows that your overall goals are better met by product elimination and concentration of efforts. An evaluation of the contributions products make to your objectives often reveals that the assets dedicated to production of a particular product, if expended on the production of a more profitable item, will create greater returns.
Warning Signals Indicating Product Difficulties
- A decline in absolute sales volume
- Sales volume decreasing as a percentage of the firm’s total sales
- A decrease in market share
- Sales volumes not up to projected amounts
- Unfavorable future market potential of products
- Return on investment below minimally acceptable levels
- Variable cost in excess of actual revenues
- Costs, as a percentage of sales, consistently increasing
- An increasingly greater percentage of managerial and executive oversight necessary for the product
- Repeated price reductions necessary to maintain current or projected sales levels
- Increased promotional budgets necessary to maintain sales
- Increasing product returns
For most of these indicators, a simple graph on a month-by-month basis can quickly show trends. The graph then becomes a simple budget-tracking device.
The key to a successful elimination program is the availability of timely and pertinent information. This is true of all major business decisions. Accounting sources provide the requisite raw data on which you may decide which products to discontinue, which to retain, and which to expand or contract in your business plan.
“What happens if things go sour?” is a question that few people want to think about. Although the answers do not always yield clear-cut decisions, they do provide input to the go/no-go decision. Furthermore, the use of the bailout consideration forces some planning.
To consider bailout, start by asking questions. For example:
What can we bail out with if the project must be shut down after two years?
Then look at cash flows (discounted, of course) through that period, including salvage. Because a likely reason to bail out may be lack of sales, lowered sales estimates should be substituted for original estimates. All this can be done in the same format previously used to estimate net present value.
An important value of the bailout consideration is that it reminds you that things do not always go as planned. Many people are eternally optimistic and will resist looking at “the dark side.” But such considerations can result in much more protection for the remainder of your business should projections not come to pass.
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