No matter how well you evaluate proposed capital investments, your investment decisions will be based on estimates about future net cash flows.
As there is always an element of risk involved, you should also use one of the following techniques in your investment evaluations:
- Adjusting cash flow estimates
- Adjusting required payback period
- Adjusting required rate of return.
Adjusting cash flow estimates
When you are considering the future, you should not rely on just one set of figures. You should make a number of net cash flow estimates including the most optimistic, most likely and the worst case scenarios.
By considering the worst and the best case scenarios and the range in between, a business can get a ‘feel’ for the risk of an investment. Rarely does the ‘best case’ scenario eventuate, so viewing a ‘spread’ of figures allows you to make a more informed decision. Compare the results and choose the most favourable.
Once you have undertaken a certain direction over a period of time, you may need to change your planning or strategy depending on the results.
A good business manager is able to adapt quickly to what is happening in the market or implement changes where expected outcomes are not achieved. This is a particular challenge for service/retailers, where often stock levels are pre-committed and ‘off loading’ slow moving stock is a challenge.
The above cash flow approach can be used in conjunction with both the Payback Period and the Net Present Value technique.
Adjusting Required Payback Period
The shorter the payback period the less opportunity there is for something to go wrong. This is because there are fewer unknowns. So when choosing between two or more competing investments it pays to choose the one with the shortest payback time. This will help reduce any risk.
Required Rate Of Return
The interest rate used in the Net Present Value calculation should be equal to the best return you could obtain elsewhere from an investment of similar risk. The required rate of return has two elements:
1. A return for waiting a period of time for your eventual financial return, and an adjustment to take into account expected inflation. That is the risk-free rate of interest.
2. Extra interest for taking risks.
It is not easy to know how much you should be compensated for risk. For guidance, look at returns you have achieved in the past and returns achieved by other businesses in the same industry. Look also at the ‘risk-free’ investment returns (eg. bank interest). Your rate should be higher than this to reflect the greater risk.
When Should You Plan To Replace An Asset?
As an established business, you know that nothing lasts forever, so when a fixed asset nears the end of its useful economic life, you should review its continued use by the same methods you used to decide whether to acquire the asset for the business in the first place.
Compare the present value (at the time of the review) of the net cash flows still to come, with the scrap value which could be received if the asset was sold now.
If the scrap value of the asset now is greater, retire the asset. It’s simply not worth keeping.
Whether or not you replace it with another similar asset is a new investment decision. Refer to the capital expenditure discussion previously.
For businesses, image is important so you should consider budgeting for a ‘re-fit’ of your premises every few years.
Any planning for future investments must include financial projections. How do you make these? In the absence of a crystal ball, all you can do to predict the future is to look at past results and project them into the future.
If, for example, income from products and services has been $7,000, $6,500, $8,000, $5,900, $8,200 and $7,800 for the past six months, it is fair to assume that next month’s income will be around the average of these months, namely $7,233.
Alternatively, you can use software products, such as Microsoft’s Excel, to chart projected increases or decreases in revenue based on your expectations.
The same applies to projected costs. In fact, variable costs should be directly related to income, although with an element of time lag. You can also extrapolate projected profits, although with less certainty.
Most businesses have fixed costs which are incurred regardless of turnover. Therefore, whilst operating costs may be fairly predictable (in line with revenue), revenue estimates (and profitability) can vary greatly.
You should make commonsense estimates based on past performances and changes you know have taken place or are likely to take place, such as any seasonal increases in income.
It is important to also factor in that businesses also have to account for some seasonal fluctuations. Obviously, a restaurant would experience high demand at Valentine’s Day and Mother’s Day whereas a cabinet maker could see higher returns closer to Christmas. You need to factor these swings into any cash flow projections.
Always remember that financial projections are little better than educated guesses. Their ‘worth’ is how ‘educated’ are those guesses. Nevertheless, financial projections or budgeting are an important aspect of financial management. They provide some expectation of the future.