Financial appraisal or evaluation is a must for every project even though the outcome may not be the decision criteria for establishing the project. Financial appraisal of a project deals with cash flows. Cash, which goes out of the firm, is known as cash outflow. Typically an investment in a project is an out flow. The cash that is received in future from the project is an inflow. We should remember that cash is different from income. Cash flow and not income flow is central to project evaluation. The results of an evaluation of a project are only as good as the accuracy of our estimation of cash flows. The following illustrates computation of cash outflow.
Cash outflow on installation of a machine includes;
- Cost of new equipment
- Labor and erection costs
- Maintenance cost
While computing such outflows we should not include interest costs on debt employed. If the cost is not incurred all at once but over a period of time say as in installment purchase then the out flow will continue in subsequent years also till the entire cost is paid out. In computing cash flows sunk cost are ignored and only incremental costs and benefits must be considered. If the machinery bought has any scrap value or salvage value the same would be an inflow in the year of actual receipt and this may improve the overall cash flow pattern. When the implementation of a project involves additional inventory receivables etc., then the same are treated as cash outflow at the time they occur. As increase or decrease in working capital can occur at any time during the project, the incremental working capital (increases) treated as outflows and decreases treated as inflows when they occur. In the case of replacement of an existing asset with a new one, any salvage value or sale value of the old asset should be treated as cash inflow and the cash outflow should be accordingly adjusted.
Estimation of cash inflows is comparatively more difficult and calls for greater caution and accuracy. The correct computation of cash inflows depends upon accurate estimation of production and sales. The additional sales, the selling price, gross revenue and the costs associated with such sales need to be estimated. It is important that while estimating the revenues, one should consider possibilities like selling price reduction due to competition, labor cost going up, production delays and losses etc., In essence the estimate takes into account possible future down sides and likely changes in the business environment. It is important that while estimating the cash flows the effect of inflation is also considered. But if the effect of inflation is considered at the time of estimating the net revenue or net savings, then the same need not be adjusted at the time of evaluation.
However while considering costs, the interest associated with the cost should not be considered. In evaluation of proposal, the required return or the cost of capital used as a discounting factor would include the interest /dividend cost. A separate inclusion would therefore result in double counting and hence to be avoided.
Depreciation is an important factor in computing cash flows but it must be remembered that the incremental depreciation alone can be accounted in the computation. Similarly the net revenue should be adjusted for tax and the cash flow is computed as after tax cash flows.
Some times cash flows are computed in terms of net savings. This happens when an old machine is replaced with a new machine and savings are obtained. As in the case of net revenue these savings have to be adjusted for depreciation and tax.