Investment appraisal is built around estimates of future cash flows - cash flow into and out of the company as a result of a particular investment project.
These are almost certainly not entirely accurate. The capital cost will not really be known until it is actually done. Plus or minus 5% would be a good level of accuracy from a good, experienced project team. Cash inflows are also notoriously hard to predict with any accuracy.
This is all the costs of the project. It will be built up by the 'Projects Department', often using a series of sub-estimates that are aggregated to get the overall cost.
Follow the link below to see an example of a possible project cost pro-forma.
Every effort is made to cover all items that may be required. Note the inclusion in the above proforma of the words 'Contingencies'. What are they, and why are they needed?
This is the estimate of the value of the project. It is expressed in terms of net cash inflow.
Net cash inflow
Net cash flow is the additional cash a project will generate (sales revenue or cost savings) less annual costs incurred in processes such as the manufacture and sale of a product.
The heart of the forecast of net cash inflow is the sales forecast produced by the marketing department. This may possibly be inaccurate as it is a forecast. This inaccuracy may be magnified if there are also problems with the cost side of net cash inflow.
Follow the link below to see an example of a possible net cash flow pro-forma.
Notice that it is a cash flow forecast, not a profit forecast. We are concerned with real money here.
Cash inflows often tend to be overestimated. Brand managers who have committed themselves to their new product are rarely pessimistic about sales or they may do themselves out of a job! Marketing people tend to be optimists - the product will sell well - so the sales forecast will probably be an overestimate of the real situation.
Reasons for this inaccuracy are:
- Firms do not work in a vacuum. They cannot predict accurately the actions of the competition, the development of the market, changes in consumer taste, and changes in the economy and government regulation.
- Firms cannot always accurately predict the prices of materials or the cost of labour in advance. These prices may fluctuate daily.
- The weather may be very unseasonable and cause sales to be different to the forecast.
- Some other items, such as agricultural products are difficult to predict in advance.
A severe drought destroyed one-fifth of the wheat crop in Russia, one of the world's largest exporters. The majority of the damage to Russia's wheat crop has been caused by the drought, one of the worst in decades as much of the country suffers through the hottest summer since record-keeping began 130 years ago. But in recent days, wildfires raging through much of western Russia have spread and there are fears that more fields will be lost.
Expectations that Russia will slash exports by at least 30 percent have sent wheat prices soaring. "Russia has become the price-maker on the market," said Dmitry Rylko, director general of the Institute for Agricultural Market Studies, who says he expects minimal exports.
Wheat prices on the Chicago Board of Trade surged in July by 42 percent, the biggest monthly gain in more than a half century, and are now the highest they have been in nearly two years. With no immediate end in sight for the drought in Russia, analysts expect prices to continue to rally.
Thus there is a considerable element of risk when cost figures are used; which is another reason to ensure a contingency is included in the budget. The results of investment appraisal need to be considered in the light of uncertainty in the market, the reliability of the source and the quality of the data involved. An allowance should be made for the risk element.