FREE online courses on Investment Appraisal - Basic Concepts of Investment Appraisal - Cash Flow

 

In considering investment decisions, it does not matter whether outlays are
termed 'capital' or 'revenue' nor whether inflows are turned 'profit', 'depreciation',  'tax allowance', or whatever. All outlays and income must be taken into
account.

 

Cash flows in this context is not the same as the cash flow through a bank account, nor is it identical to accounting profit, since changes in the later can occur without any change taking place in the cash flow.

 

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:

1.                  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.

2.                  Operating costs: Running costs of the operations that are required to generate income. These include both the variable and the fixed costs.

3.                  Revenue: Realizations 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.

4.                  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.

5.                  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.

6.                  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.

 

The application of risk analysis enables management to answer the following questions: (1) What is the profitability resulting from given estimates of costs and revenues from the project, if they are achieved? and (2) What is the likelihood of such estimates being achieved?

 

This then enables top management to concentrate on those factors that are critical to the financial success of the project, such as selling price, sales volume, capital cost, and so forth.

 

Measuring cash flows is not a very tedious job if they exist, but always remember you are talking about future projections in these cash flows and projections are perceptions that change with each person.