Estimating cash flows — the investment outlays and the cash inflows after the project is commissioned — is the most important, but also the most difficult step in capital budgeting. Estimating cash flows process involves many people and numerous variables.
A project which involves cash outflows followed by cash inflows comprises of three basic components. They are,
- Initial investment: Initial investment is the after-tax cash outlay on capital expenditure and net working capital when the project is set up.
- Operating cash inflows: The operating cash inflows are the after-tax cash inflows resulting from the operations of the project during its economic life.
- Terminal cash inflow: The terminal cash inflow is the after-tax cash flow resulting from the liquidation of the project at the end of its economic life.
For developing the stream of financial costs and benefits, the following principles must be kept in mind:
1. Principle of Incremental Cash Flows
The cash flows of a project must be measured in incremental terms. To ascertain a project’s incremental cash flows, one has to look at what happens to the cash flows of the firm with the project and without the project. The difference between the two reflects the incremental cash flows attributable to the project.
That is;
Project Cash Flow for year t = Cash flow for the firm with the project for year t – Cash flow for the firm without the project for year t
In estimating the incremental cash flows of a project, the following guidelines must be borne in mind:
- Consider all incidental effects
- Ignore sunk costs
- Include opportunity costs
- Question the allocation of overhead costs
2. Principle of Long Term Funds
A project may be evaluated from various points of view: total funds point of view, long term funds point of view, and equity point of view. The measurement of cash flows as well as the determination of the discount rate for evaluating the cash flows depends on the point of view adopted. It is generally recommended that a project may be evaluated from the point of view of long-term funds (which are provided by equity stockholders, preference stock-holders, debenture holders, and term-lending institutions) because the principal focus of such evaluation is normally on the profitability of long-term funds. This argument, though plausible, cannot be regarded as unassailable. Nonetheless, we subscribed to the position that it is quite reasonable to view a project from the long-term funds point of view. Hence for determining the costs and benefits of an investment project we will raise the questions. What is the sacrifice made by the suppliers of long term funds? What benefits accrue to the suppliers of long-term funds? The sacrifice made by the suppliers of long-term funds is equal to the outlays on fixed assets and net working capital (it may be recalled that net working capital, which represents the difference between current assets and current liabilities, is supported by long-term funds). The benefits accruing to the suppliers of long-term funds consist of operational cash inflows after taxes and salvage value of fixed assets and net working capital.
3. Principle of Financing Costs Exclusion
When cash flows relating to long-term are being defined, financing costs of long-term funds [interest on long-term debt and equity dividend] should be excluded from the analysis. Why? The weighted average cost of capital used for evaluating the cash flows takes into account the cost of long-term funds. Put differently the interest and dividend payments are reflected in the weighted average cost of capital. Hence, if interest on long term debt and dividend on equity capital are deducted in defining the cash flows, the cost of long-term funds will be counted twice – an error that should be carefully guarded against.
Operationally, the exclusion of financing costs principle means that
- The interest on long-term debt [referred to hereafter as just interest for the sake of simplicity] is ignored while computing profits and taxes thereon and
- The expected dividends are deemed irrelevant in cash flow analysis.
While dividends pose no difficulty as they come only from profit after taxes, interest needs to be handled properly. Since interest is usually deducted in the process of arriving at profit after tax, an amount equal to interest [1 -tax rate] should be added back to the figure of profit after tax. Thus, whether the tax rate is applied directly to the profit before interest and tax figure or whether the tax adjusted interest, which is simply interest [1-tax rate], is added to profit after tax, we get the same result.
4. Principle of Post-tax
Tax payments like other payments must be properly deducted in deriving the cash flows. Put differently cash flows must be defined in post-tax terms [It may be noted that the cost of capital employed for evaluating the cash flow stream is also measured in post-tax terms].