Cost of Capital^71
For purposes of investment appraisal, the cash flow is the incremental cash
receipts less the incremental expenditures solely attributable to the investment in question.
The future costs and revenues associated with each investment alternative are:
- Capital costs: These cover (a) the long-term capital outlays necessary to finance
a project, and (b) working capital. Typically additional working capital will be
required to cover a higher inventory, or a larger number of debtors, and to be
worth while the project must earn a turn on this capital as well as on the long-term
capital. - Operating costs: Running costs of the operations that are required to generate
income. These include both the variable and the fixed costs. - Revenue: Realisations from the sale of goods produced as well as other income
which is not directly attributable to operations but contributes to the profitability of
the operations. - Depreciation: In the case of the discounting methods of appraisal, the recovery
of capital is automatically allowed for from the net cash flow, so depreciation
need not be included as an accounting provision. This has the important advantage
that the discounting profitability assessment is not affected by the pattern of
accounting depreciation chosen. - Residual value: As with working capital, the residual assets of the project may
have a value. This residual value should be included with the net cash flow.
An investment decision implies the choice of an objective, a technique or appraisal, and
length of service-the project's life. The objective and technique must be related to
definite period of time.
No matter how good a company's maintenance policy, its technological forecasting
ability, or its demand forecasting ability, uncertainty will always be present because of
the difficulty of predicting the length of project's life.
The actual assessment of a project's profitability is a team exercise in which the expertise
of economist, the market researcher, the engineer, and the controller must all be brought
together. The outcome of their collaboration will be a forecast of the cash flow over a
period of yeaRs If this period is incorrectly estimated, the whole analysis will be wrong
or at least grossly inaccurate.
As a rule, in investment appraisal, one of two assumptions is adopted-either the cash
flow is assumed to be known with certainty, or the best estimate is used. The assumption
of certainty is generally unacceptable, so allowance must be made for the risk inherent
in the proposed adoption of the 'best' estimate. To the expected outcome, probabilities
can be attached to sales, costs, and other elements of the investment proposal to allow
for risk.