Do cash flows really occur at year ends?
In the examples that we have considered so far, all of the cash flows have occurred
exact numbers of years after the start of the project. This obviously is not very representative of real life.
Most investments undertaken by businesses are in land, buildings, plant, machinery, trading inventories and so forth. The returns from these are in the form of sales
revenues against which have to be set costs of labour, materials and overheads.
Clearly, these cash flows are not likely to occur at year ends. They tend to be spread
throughout the year, perhaps fairly evenly or perhaps more concentrated at some
parts of the year than at others, reflecting the seasonal aspect of certain trades.
Strictly, the precise timing of the cash flows should be identified and they should
be discounted accordingly. The discount factor 1/(1 + r)
n would be the same; however,
the n would not necessarily be a whole number.
Although it would be perfectly feasible to recognise the precise timing of cash
flows, it seems not to be usual to do so. The simplifying assumption that cash flows
occurring within a year occur at the year end is thought to be popular in practice.
Making this assumption tends to introduce an element of bias in that it usually treats
cash flows as occurring a few months later than they actually do. This tends to have
A project that involves an initial outlay of £200,000 on a machine is expected to generate annual profits of £60,000 (after deducting depreciation) each year for four years.
Depreciation is calculated on an even (straight line) basis, assuming that the disposal proceeds of the original investment will be £40,000 receivable at the end of year 4. This means
that the annual depreciation expense will be £40,000 [(£200,000 − £40,000)/4]. The initial cost
is an outflow in year 0 (immediately) and the disposal proceeds are an additional inflow in
year 4.
5.4 Which cash flows?
As we saw in Chapter 2, only those cash flows relevant to the decision should be
brought into the appraisal. Cash flows will be relevant only where they will be different, depending upon the decision under review. Items that will occur regardless of the
decision should be ignored. For example, where a decision involving a choice as to
whether or not to make a new product would not have an effect on the fixed overheads, the fixed overheads should be disregarded when making the decision; they will
be unaffected by it.
Similarly, past costs are irrelevant as they will inevitably be the same whatever
happens in the future. For example, where a machine costing £50,000 one year ago is
under review as to whether or not it should be replaced, the decision should not take
the £50,000 into account. Only the future benefits that could be derived from the
machine, in terms of either proceeds of disposal or cash flow benefits of its retention,
should be considered. The present decision is not whether or not to buy the machine
a year ago; that decision was made over twelve months ago and was either a good or
a bad one. In either case it is not something that can now be altered.
Opportunity cash flows
It is not only cash flows that are expected actually to occur that should be taken into
account. Opportunity cash flows are as important as actual cash flows. In the above
example, if the machine has a current market value of £10,000 then one of the cash
flows associated with retaining the machine will be a £10,000 outflow at whatever time
it would be disposed of if the alternative action (disposal) were followed. Obviously,
if the machine is retained this cash flow will not actually occur; nonetheless it should
be taken into account because retention of the machine deprives the business of the
opportunity to dispose of it. The £10,000 represents a difference arising from the decision. Some opportunity cash flows may be fairly remote from the project under review
and so can quite easily be overlooked unless care is taken. An example of such opportunity cash flows is losses of sales revenue (and variable costs) of one of the business’s
existing activities as a result of introducing a new one. For example, a chain store contemplating opening a new branch should not just assess the cash flows of that branch.
It should also consider cash flow changes that might occur in other branches in the
locality as a result. Sales revenue might be lost at existing branches if a new one is
opened.
The high street retailer Next plc makes the point in its 2007 annual report that
‘When appraising a new store we account for the loss of sales and profit from nearby
stores that we expect to suffer a downturn as a result of the new opening.’
Forecasting cash flows
Investment appraisal deals with forecasts of future cash flows. Forecasting the cash
flows associated with particular courses of action is likely to be difficult, and subject
to error. Details of the techniques and problems of forecasting go beyond the scope of
this book. These techniques include the use of statistical data on past events (generated inside and outside the business), market research projects and soliciting the opinions of experts.
Financing costs – the cost of capital
One type of cash flow that should not be included in the appraisal is the cost of finance
to support the project. Discounting deals with the financing cost in a complete and logical manner in that future cash flows are reduced (discounted) to take account of the
time for which finance will be tied up and the relevant interest rate.
So far we have referred to the cost of financing as ‘interest’, as though all finance
is provided through borrowing. In practice, most businesses are financed by a mixture of funds provided by the owners (shareholders in the case of limited companies)
and borrowing. Thus the financing cost is partly the cost of equity and partly interest
cost. We tend to use the expression cost of capital for the overall cost of financing
and for the basis of the discount rate. This expression will generally be used from
now on.