Here is a list of ten cash flow items to be considered in evaluating a capital budget proposal. This list is not intended to be exhaustive. However, these items should be carefully scrutinized for every proposal so that you can make a complete evaluation of appropriate costs:
- Plant and equipment items
- Installation and debugging of equipment and systems
- Inventories including consideration of: raw materials, work-in-process, finished goods, spare parts.
- Market research and product introduction
- System changes necessitated by engineering changes and product redesign
- Accounts receivable
- Accounts payable
- Taxes, to include: income, investment tax credits, property tax, credits.
- Cash and requirements for cash working capital
Inflation and Cash Flow Estimates
When estimating cash flows, inflation should be anticipated and taken into account. Often there is a tendency to assume that the price for the product and the associated costs will remain constant throughout the life of the project. Occasionally this assumption is made unwittingly, and future cash flows are estimated simply on the basis of existing prices. If anticipated inflation is embodied in the required return criteria, it is important that it also be reflected in the estimated cash flows from the product over the life of the project. To reflect cash flows properly in later periods, consider adjusting both the expected sales price and the expected costs by reasonable inflation numbers.
You may assume that if all proposals are evaluated without consideration of inflation, the decision matrix will be unchanged. This is not necessarily the case. As in the case for the generation of internal rates of return, inflation will change future cash flows relative to the year in which they occur by the inflation rate specific to that product or industry. Therefore, by not anticipating inflation and assigning values for particular future time periods, the decision model may be biased by not taking into account the different effects on cash inflows and outflows as a result of different rates of inflation.
As a result, the project selection may not be optimal. Discounted Cash Flow Because the primary concern is discounted cash flow, we should begin our discussion with the required rate of return. This rate is called by many names, including hurdle rate, cost of capital, interest rate, and discount rate.
Actually, hurdle rate is probably best. It implies a barrier, in terms of the return on investment, which the proposal must clear in order to be considered. The other names arise from the mistaken idea that the cost of capital or interest, which is the cost of some of the capital, is the criterion for judging the investment. A weighted average cost of capital has been suggested; for small businesses, it may not be difficult to calculate because of the limited sources of capital employed. However, neither the marginal cost of capital nor the weighted average cost of capital alone take into account other factors that should be considered in deciding on a required return or hurdle rate to be used, such as:
- The relative risk of this proposal to other proposals
- Other opportunities
- Return on other investments already made
- The company’s loan limit
There is no magic formula for the evaluation of all the relative factors used in arriving at a correct rate. However, you are encouraged to consider the following questions:
- How much return do you usually get?
- How much return can you reasonably expect to receive?
- How much does it cost you to borrow?
- How much should you penalize the proposal for the risk involved?
For many businesses, a simple formula for normal risk projects might be:
Discount rate = Centeral Bank Prime Interest Rate + 3 points (borrowing premium) + 4 to 6 points risk premium
This is, of course, a very rough rule of thumb and should be used with all appropriate caution!.
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