MULTI-PERIOD CAPITAL RATIONING AND MATHEMATICAL PROGRAMMING
After 1 After 2 After 3 NPV IRR Project Immediately year years years (at 10%) (to nearest 1%)
6.2 INCREMENTAL CASH FLOW ANALYSIS
We stressed in the previous chapter that the financial input into any investment deci- sion analysis should be based on the incremental cash flows arising as a consequence of the decision. These can be found by calculating the differences between the forecast cash flows from going ahead with the project and the forecast cash flows from not accepting the project.
This is not always easy. To illustrate this point, we consider how investment analy- sis handles opportunity costs, sunk costs, associated cash flows, working capital changes, interest costs and fixed overheads.
■ Remember opportunity costs
Capital projects frequently give rise to opportunity costs. For example, a company has developed a patent to produce a new type of lawnmower. If it makes the product, the
expected NPV is £70,000. However, this ignores the alternative course of action: to sell the patent to another company for £90,000. This opportunity cost is a fundamental ele- ment in the investment decision to manufacture the product and should be deducted from the £70,000, giving a negative NPV of £20,000. The in-house production option is not wealth-creating – and the sale of the patent appears to be more attractive.
Opportunity cost example: Belfry plc
We often see opportunity costs in replacement decisions. In Belfry plc, an existing machine can be replaced by an improved model costing £50,000, which generates cash savings of £20,000 each year for five years, after which it will have a £5,000 scrap value.
The equipment manufacturers are prepared to give an allowance on the existing machine of £15,000, making a net initial cash outlay of £35,000. But in pursuing this course of action, we terminate the existing machine’s life, preventing it from yielding
£3,000 scrap value in three years. The prospective scrap value denied is the opportuni- ty cost of replacing the existing machine. The cash flows associated with the replace- ment decision are therefore:
Year 0 Net cost (£35,000)
Years 1–5 Annual cash savings (£20,000)
Year 3 Opportunity cost (scrap value forgone on old machine) (£3,000)
Year 5 Scrap value on new machine £5,000
■ Ignore sunk costs
By definition, any costs incurred or revenues received prior to a decision are not rele- vant cash flows; they are sunk costs. This does not necessarily imply that previously- incurred costs did not produce relevant information. For example, externally conducted feasibility studies are often undertaken to provide important, technical, mar- keting and cost data prior to a major new investment. However, the costs of the study are excluded from project analysis. We are concerned with future cash flows arising as a particular consequence of the course of action.
■ Look for associated cash flows
Investment in capital projects may have company-wide cash flow implications. Those involved in forecasting cash flows may not realise how the project affects other parts of the business – senior management should therefore carefully consider whether there are any additional cash flows associated with the investment decision. The decision to produce and launch a new product may influence the demand for other products with- in the product range. Similarly, the decision to invest in a new manufacturing plant in Eastern Europe, or to take over existing facilities, may have an adverse effect on the company’s exports to such countries.
Self-assessment activity 6.2
Waxo plc has developed a new wonder earache drug. The management is currently putting together an investment proposal to produce and sell the drug, but is not sure whether to include the following:
1 The original cost of developing the drug.
2 Production of the new product will have an adverse effect on the sale of related prod- ucts in another division of Waxo.
3 Instead of producing the drug internally, the patent could be sold for £10 million.
How would you advise Waxo on the relevant costs?
(Answer in Appendix A at the back of the book)
Self-assessment activity 6.3
Rick Faldo – the marketing manager of a manufacturer of golf equipment — has recently submitted a proposal for the production of a range of clubs for beginners. He has just
■ Include working capital changes
It is easy to forget that the total investment for capital projects can be considerably more than the fixed asset outlay. Normally, a capital project gives rise to increased stocks and debtors to support the increase in sales. This increase in working capital forms part of the investment outlay and should be included in project appraisal. If the project takes a num- ber of years to reach its full capacity, there will probably be additional working capital requirements in the early years, especially for new products where the seller may have to tempt purchasers by offering more than usually generous credit terms. The investment decision implies that the firm ties up fixed and working capital for the life of the project.
At the end of the project, whatever is realised is returned to the firm. For fixed assets, this will be scrap or residual value – usually considerably less than the original cost, except in the case of land and some premises. For working capital, the whole figure — less the value of damaged stock and bad debts – is treated as a cash inflow in the final year, because the finance tied up in working capital can now be released for other purposes.
Occasionally, the introduction of new equipment or technology reduces stock requirements. Here the stock reduction is a positive cash flow in the start year; but an equivalent negative outflow at the end of the project should be included only if it is assumed that the firm will revert to the previous stock levels. A more realistic assump- tion may be that any replacement would at least maintain existing stock levels, in which case no cash flow for stock in the final year is necessary.
■ Separate investment and financing decisions
Capital projects must be financed. Commonly, this involves borrowing, which requires a series of cash outflows in the form of interest payments. These interest charges should not be included in the cash flows because they relate to the financing rather than the investment decision. Were interest payments to be deducted from the cash flows, it would amount to double-counting, since the discounting process already considers the cost of capital in the form of the discount rate. To include interest charges as a cash out- flow could therefore result in seriously understating the true NPV.
Some companies include interest on short-term loans (such as for financing season- al fluctuations in working capital) in the project cash flows. If so, it is important that both the timing of the receipt and the repayment of the loan are also included. For example, the NPV on a 15 per cent one-year loan of £100,000, assuming a 15 per cent discount rate, must be zero: £100,000 cash received today less the present value of interest and loan repaid after a year (i.e. £115,000/1.15).
■ Fixed overheads can be tricky
Only additional fixed overheads incurred as a result of the capital project should be included in the analysis. In the short term, there will often be sufficient factory space to house new equipment without incurring additional overheads, but ultimately some additional fixed costs (for rent, heating and lighting, etc.) will be incurred. Most facto- ries operate an accounting system whereby all costs, including fixed overheads, are charged on some agreed basis to cost centres. Investment in a new process or machine frequently attracts a share of these overheads. While this may be appropriate for accounting purposes, only incrementalfixed overheads incurred by the decision should be included in the project analysis.