Once the cash flows have been determined from the capital
budgeting cash flow worksheet, they are listed on the capital budgeting
evaluation worksheet. To be able to fill the worksheet, you will
need present value table for some periods (e.g.: 5-15 years), at various rates
(e.g.: from 5 percent to 30 percent). It is best to keep this table together with the capital
budgeting worksheet so that later referral to the worksheet will not result in
questions concerning the origin of the numbers used in your calculation.
The use of the evaluation worksheet is
straightforward: The cash flows are
taken from the cash flow worksheet and are listed in column 2. In column 3, the
first trial percentage rate is listed to generate the present value of income
flow. Column 4 is read directly from the present value table for the first
trial interest rate. Those numbers are filled into the form from the matrix.
Column 5 is the multiplication of the cash flow from column 2 by the present
value factor from column 4. Column 6 is used for a second trial percentage.
Once again the process is repeated and the present value rates are included in
column 7 for the second percentage selected. Column 8 is again calculated by the
multiplication of the cash flows from column 2 and, this time, the present
value numbers in column 7. In this manner, two trials can be made to evaluate
the present values of a single cash flow estimate over two different discount
rates. Using these worksheets, the cash flows for various proposals may be
compared.
Improving the Estimates
In most cases, the unfortunate truth is that
things normally can get only a little bit better but a whole lot worse than
expected. Therefore, if the distribution of possible outcomes is considered, it
probably would be skewed to the left, in that there is a greater number of
unfortunate outcomes than fortunate ones. The possibility of improvement is
also limited by the production capabilities. Therefore, the limiting factor on
the right side may be plant capacity. Since capacity is normally added in
significant increments as opposed to one or two units at a time, there is no
continuum of outcome possibilities. Instead, production capacities occur in
steps. Without getting into the problem of analyzing additional production
quantities, consider the problem of improving the estimates from the standpoint
of fixed or limited capacity.
The problem encountered in capital budgeting, as in all other planning, is that a “most
likely” figure is normally offered. However, other alternatives should be
considered. This situation is not uncommon: “most likely” sales estimate is
$300,000; “best case” (limited by capacity) is $400,000; “worst case” sales
estimate is $100,000. One way to use this information is to multiply each by
some estimated probability. For example, the probable outcome for “most likely”
may be estimated as 5 chances out of 10; “best” is 2 chances out of 10; and
“worst” is 3 chances out of 10. To calculate the expected outcome, we start by
multiplying the “most likely” sales estimate by 5 and repeat this process for
each outcome.
So:
Sum up the probabilities of 5, 3, and 2 for a total of 10. Finally, divide the
sum of the multiplications by the sum of the probabilities.
The expected value is: $2,600,000/10 = $260,000. The resulting
expected value amount of$260,000 is less than
the most likely figure of $300,000 and reflects the fact that the curve is skewed to the
left. While $300,000 is still most likely, a conservative
estimate of $260,000 is also
reasonable.
Although
not impressive statistically, this approach does make use of more information; this
fact usually would justify its inclusion in cash flow projections. Understand that each of the figures—the sales figures and the
probabilities associated with each of the three cases—is an estimate. In making
these estimates, you should take care to ask a lot of what-if questions.
When
trying to evaluate what is behind the numbers, it is also extremely important to
evaluate the information sources. As mentioned previously, engineers may tend to underestimate
time to complete projects and thereby underestimate costs. Marketing and sales
personnel may overestimate sales and sales potentials. Then, ask:
How good are the forecasts of the market, the economic
conditions and the expectation of future cash flows?
Often it is necessary to question where
the numbers came from, who generated them, on what assumptions they were based,
and what data were used. It is helpful to know the sources of data, the age of
the data, and the method of generation.
Often these sources are used:
- Government publications, which give useful information on the trends in the economy, consumer spending, and other market information
- Private company publications such as Chase Econometric, Dow Jones, and the like.
- Trade publications
- Newspapers
Experience in the industry usually helps
provide an understanding about the availability and reliability of certain
information and data sources.
A major task in capital budgeting is estimating future cash
flows. The quality of the
final budget and plan is really only as good as the accuracy of the estimates.
You should have efficient procedures set up to collect the information
necessary for capital budgeting decisions. Try to standardize this information
as much as possible for all investment proposals; otherwise, proposals cannot
be compared objectively.
One of the more difficult capital budgeting problems to evaluate
concerns projects associated with environmental protection or safety. It is difficult in those projects to
quantify the net cash flows because in most cases the benefit to you is more in
the nature of a cost avoidance.
The reason the expected benefits from a particular project are
expressed in terms of cash flows rather than in terms of income is that cash is
central to all your decisions. You invest cash now in the hopes of receiving cash returns of
a greater amount in the future. Only cash receipts can be reinvested or paid to
stockholders in the form of dividends. Thus cash, not income, is what is
important in capital budgeting.
Futher worth reading about capital budgeting:
accounting-financial-tax.com/2008/09/capital-budgeting-evaluation-worksheet-improving-estimates/
