Accurate estimation of project cash flows is a critical element in capital investment decisions. It directly influences project evaluation, financing choices, and risk assessment. The following factors significantly affect the estimation of cash flows:
1. Effect on Other Projects
When a project is not economically independent, its impact on other existing projects must be considered. For example, launching a new product that competes with an existing product may reduce the cash flows of the older product. According to the incremental cash flow principle, only changes in cash flows resulting from undertaking the project should be considered. Projects should not be evaluated in isolation if they influence other operations or investments.
2. Effect of Indirect Expenses (Overheads)
Overheads are often allocated across products based on wages, materials, floor space, or other criteria. These should be included in cash flow estimates only if they will change as a direct result of the investment decision. If overheads remain unaffected, they are not relevant to the cash flow analysis.
3. Effect of Depreciation
Depreciation, though a non-cash expense, affects cash flows through tax savings (tax shields) by reducing taxable income. Proper consideration of depreciation is vital in capital budgeting, as it impacts key metrics such as Net Present Value (NPV) and Internal Rate of Return (IRR).
4. Effect of Working Capital
Changes in working capital items—accounts receivable, inventory, and accounts payable—must be adjusted when converting accounting profits to actual cash flows:
• Accounts Receivable: Increases reduce actual cash inflows; decreases increase them.
• Inventory: Increases require additional cash outflow; decreases release cash.
• Accounts Payable: Increases delay cash outflow; decreases accelerate payments.
Instead of adjusting each item separately, the net change in working capital can be used:
– An increase in net working capital is subtracted from after-tax operating profit.
– A decrease is added to after-tax operating profit.
Release of Net Working Capital
At the project’s termination, funds tied up in working capital may be recovered, partially or fully. The actual amount recovered is considered a terminal year cash inflow.
5. Effect of Salvage Value
Salvage value—the net proceeds from selling an asset at the end of its useful life—forms part of the terminal cash flows:
• The salvage value of a new asset increases the terminal year’s cash inflow.
• The salvage value of an existing asset can reduce the initial outlay for a replacement asset.
• If an existing asset is sold before the end of its normal life, its salvage value reduces the cash flow in that period.
Any removal or disposal costs must be deducted when calculating salvage value.
Importance of Accurate Cash Flow Estimation
1. Project Evaluation – Techniques such as NPV, IRR, and Payback Period depend on reliable cash flow estimates. Inaccurate figures can lead to acceptance of unprofitable projects or rejection of profitable ones.
2. Risk Assessment – Estimating cash flows under best-case, worst-case, and most-likely scenarios helps assess project risk and potential variability in returns.
3. Financing Decisions – Understanding the timing and magnitude of cash requirements aids in planning financing strategies, whether through debt, equity, or internal resources.
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