Cash Flow Computations in Project Management

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;

  1. Cost of new equipment
  2. Labor  and erection costs
  3. 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.

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