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:
1.
Plant and equipment
items
2.
Installation and
debugging of equipment and systems
3.
Inventories including
consideration of: raw materials, work-in-process, finished goods, spare parts.
4.
Market research and
product introduction
5.
Training
6.
System changes
necessitated by engineering changes and product redesign
7.
Accounts receivable
8.
Accounts payable
9.
Taxes, to include:
income, investment tax credits, property tax, credits.
10.
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:
1.
The relative risk of
this proposal to other proposals
2.
Other opportunities
3.
Return on other
investments already made
4.
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:
1.
How much return do you
usually get?
2.
How much return can
you reasonably expect to receive?
3.
How much does it cost
you to borrow?
4.
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!.
Futher worth reading about capital budgeting:
Source:
accounting-financial-tax.com/2008/09/capital-budget-evaluation-cash-flow-and-capital-budget-proposal/