Businesses determine and evaluate the potential capital investments through capital budgeting techniques. In most cases, a projects outflows and inflows are measured to determine whether its returns meet the estimated capital investment targets of returns, i.e. investment appraisal. The management of the businesses identifies the investments that would improve the companies competitive advantage and shareholder wealth. Usually, the capital budgeting process focus on fundamental principles that are also important in the allocation of money (Gao & Wong, 2016).
Focus on Cash Flows, not Profits
The implementation of a capital budget plan should be determined by a possible positive time value of money and also consider the risks of undertaking such investment. The capital budgeting should focus on the cash flows which are easier to forecast and calculate rather than profits based on the various aspects such as the operating income, revenue, and deductions (expenses). When a business focuses on profits during capital budgeting, it only gets conservative estimations while a focus on the cash flows would give it the best estimates that consider the risks of the capital investment projects. The cash flows represent cash which the company can reinvest and attain liquidity. If the cash flows ignored in the capital budgeting, the company may lose liquidity in those projects when implemented. When the cash flows are ignored, the projects costs and other risks might undermine the companys profitability and affect the overall value of the firm (Abor, 2017).
Focus on Incremental Cash Flows
Incremental cash flows represent the changes in cash flow that the project would have on the company. The relevant cash flows are considered before the actual evaluation of the capital budget plan. The aspects that affect the capital budgeting include sunk costs and externalities of the projects. Sunk costs are the costs that are already incurred whether the projects are accepted or not. These costs are unrecoverable and should be ignored since they do not affect the capital budgeting decisions in any way. In addition to sunk costs, other intangible costs and benefits are avoided. Externalities of the projects should also be considered in the evaluation of the investment plan. These refer to the effects that the new project would have on, the existing cash flows and operations of the firm if it is implemented. When this principle is ignored, negative externality, also known as cannibalization, can have a detrimental effect on the existing business operations. The business might also incur opportunity costs, i.e. the costs of not implementing the project or cash flow not earned as a result of the business utilizing its assets for other projects (Schonbohm et al., 2016).
Account for time
Time is an important principle in capital budgeting because the value of money changes with time due to appreciation or depreciation. In capital budgeting, it is important to take account of time as an important factor that shapes budgeting decisions. Time, therefore, should be taken into account when making credit and investment decisions. Ignoring time in capital budgeting can make an organization make wrong investments that will lead to loss of money. Also, failure to account for time can lead to the depreciation of assets making them of less value to an organization (Abor, 2017).
Account for risk
Ever organization that carries out business activities with the aim of making a profit also stands a risk of incurring a loss. Therefore, accounting for risk is important in capital budgeting because it guides in the important decision making of investment decisions as well as sources of credit for an organization. Putting risk that an organization can incur through depreciation of assets or high-interest rates helps an organization to make better decisions that can increase the organization profitability. Failure to put risk that an organization can incur into account can lead to bad investment decisions which can result in losses due to bad investment decisions (Abor, 2017).
Estimated Net Cash Flow
Cash Received Year 1 Year 2 Year 3 Year 4 Year 5 Cash from operations Cash from sales - - - - - Cash from Receivables $ 330,000 $ 330,000 $ 350,000 $ 380,000 $ 400,000 Subtotal cash (operations) $ 330,000 $ 330,000 $ 350,000 $ 380,000 $ 400,000 Additional Cash Received Non-operating (others) $130,000 $ 135,000 $ 140,000 $ 136,000 $ 142,000 Repairs and Maintenance $ 8,000 $ 13,000 $ 15,000 $ 16,000 $ 18,000 Driver costs $ 33,000 $ 35,000 $ 36,000 $ 38,000 $ 40,000 Annual depreciation $ 120,000 $ 120,000 $ 120,000 $ 120,000 $ 120,000 Subtotal Cash (Expenditures) $ 291,000 $ 303,000 $ 311,000 $ 310,000 $ 320,000 Estimating the Schools Net Cash Flow of the Assets Purchased
The estimated net cash flow is computed by assessing the cash outlay that involves the mount of inflows and outflows being generated. For the private schools purchase of the six school buses, the purchase of the assets will result to negative cash outflow. For instance, in the above computations, the annual depreciation affects the net income although it is not a cash flow project. This is the reason s to why annual depreciation is added back. However, the following steps were involved in the calculation of the estimated net cash flow;
While computing the estimated cash flow for operating activities, first begin with the net income, in this case the cash receivables. Add back non-cash expenses (130,000) for Year 1. The non-cash expenses may also include depreciation expenses. Third, you adjust for gains and losses on the sales of the assets by adding back the losses incurred (Repairs and maintenance). However, in case of any gains, we subtract them from the net income. At this point, you will have to account for any cash changes in all non-cash current assets and liabilities except and dividends amounts payable. CITATION Bil151 \l 1033 (Bill West, 2015)Computing the Payback Period of the Project;
The payback period of a project refers to the time in which the initial cash outflow of the purchase of the assets (buses) is expected t be recovered from all the cash inflows previously generated by the investment. Though the payback period of a project depends entirely on whether the cash flow per period from the project is either even or uneven, when computing the Payback period, the following procedure is undertaken;
Payback Period = Initial Investment/ Cash Inflow per Period
Payback Period = A+ B/C
Initial Investment = $ 600,000
For Year 1
Cash Inflow per Period = Year 1 = $ 291, 000
Payback Period = 600,000/291,000 = 2.1 years
For Year 2
Cash Inflow per Period = $ 303,000
Payback Period = $ 600,000/303,000 = 1.9 years
For Year 3
Cash Inflow per Period = $ 311,000
Payback Period= $ 600,000/311,000 = 1.9 years
For Year 4
Cash Inflow per Period = $ 310,000
Payback Period = $ 600,000/310,000 = 1.9 years
For Year 5
Cash Inflow per Period = $ 320,000
Payback Period = $ 600,000/320,000 = 1.9 years
Computing the payback period cumulatively, it shall be;
Year Cash Flow Payback
1 $291,000 2.1
2 $303,000 1.9
3 $311,000 1.9
4 $310,000 1.9
5 $320,000 1.9
Payback 1,535,000 1.94years
Computing the Internal Rate of Return (ROR)
While calculating the Internal Rate of Return of an asset, much consideration should be given to bringing the net present value to zero. By definition, the Internal Rate of Return refers to the profitability amount used by companies to yield the greatest return per dollar of it capital investment such as assets purchased. Basically, a businesses IRR reflects the expected gains in percentage form of the initial investment. The Internal Rate of Return can be computed using the NPV formula that is given by;
NPV is given by S (Period Cash Flow/ 1+R) t ) Initial Investment
IRR= $ 320,000/(1+ 10.5) 5
IRR = 1.591
In the above case, IRR can be computed by simply taking up the Net Profit Value. However, the IRR can be fairly straightforward for those one year projects having a single lump-sum capital investments and payout. CITATION Boy17 \l 1033 (Boyte-White, Claire, 2017)Computing the Net Present Value (NPV)
A companys Net Present Value refers to the amount that is the total of all project cash outflows and inflows that have been discounted back to the present value. When computing the net present value for the schools purchase of the 6 busses, the initial cost of the buses as well as the amount expected with the rate of return for the capital should be taken into account. CITATION Mad15 \l 1033 (Madison Garcia, 2015) For instance, if the NPV for this project is positive, this implies that the project has generated more than the required rate of return for the capital that was initially invested. The following is the computed NPV amount for the school;
NPV is given by S (Period Cash Flow/ 1+R) t) Initial Investment
R- Rate = 10.5 %
T-Time period = 5 years
Project cost = $ 600,000
Required rate of return = 1.6
The NPV for the entire period = 1535, 000/ (1+10.5) 1.6
The NPV = $30,831.299
The company should employ the Payback period to make future investment decisions. Although the Net Present Value may be the most preferable technique to determine the long term profitability, the payback period is simpler to compute. In addition, the payback period method can be used to measure the risk inherent in the project. In this regard, the future uncertainties of the occurrence of cash flow in the project the use of payback period indicate such inflows earlier.
The inherent Risk Factors associated with Capital Budgeting Analysis
Generally, capital budgeting projects are marked by large business corporations with a lead time that goes more than a year before the entity expects a return on investment. The inherent risk factors that are associated by a high number of long-term investments tend to increase the riskiness of a capital budgeting project. Although the management may accurately tell the cash flows for a given project, it may however become apparent that the project in question cannot meet the anticipated investment objectives with the more expensive material resources at the disposal. Among some of the risk factors associated with capital budgeting analysis include;
Industry-Specific Risk- the industry specific risks that may include those abrupt changes by the industrial accident or disaster tend to increase the risks of capital budgeting projects. Such abrupt regulations increases the costs associated with safety management thereby bringing capital investments to end up at a strategic and financial disadvantage.
Competition Risk-competition risk is another risk factor that can immensely cause the outcome of this project to be substantially worse than the management currently expects. Competition risks in this case, may include the unforeseen activities on the part of the competitors that may cut production costs thereby undermining the expectations of the project.
Market Risk- in the context of the school assets purchase, market risks such an increment on the interest rates and inflation may substantially increase the riskiness of capital budgeting projects. In most economies that are pertinent with such risks, the level of risk aversion investors is inherent thus creating a state of economic uncertainty.
Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Springer International Publishing. BIBLIOGRAPHY \l 1033 Bill West. (2015, May 23). How to Estimate Cash Flow of a Project. Adventure Works Montly, 12-65.
Boyte-White, Claire. (2017, March 27). What is the formula for calculating internal rate of...
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