As discussed earlier capital budgeting is identifying, selecting the best of available options and implementing long-term investment project whose returns are positive.
For selecting the best investment option future cash flow from the project are estimated and analyzed.
Relevant Cash Flow:
For decision making only incremental cash flow analysis is sufficient.
Sunk Cost is irrelevant for decision making purposes.
Opportunity Cost is relevant.
The cash flow as a result of undertaking a project can be divided into three components:
Initial Cash Flow
Operating Cash Flow
Terminal Cash Flow
Initial Cash Flow (ICF):
Cash flow in acquiring new assets/ initial investment for project. It includes cost of the machines and its shipping and installation, testing etc. For using an already owned asset the opportunity cost of the asset has to be added to cash outflow.
From this we have to subtract the after tax proceeds from the sale of old assets.
Initial cash flow also includes cash flow due to change in net working capital (NWC). Net Working Capital = Current Assets - Current Liabilities. Increase in NWC means cash outflow. Change in NWC is not tax deductible.
All these cash flows are assumed to be occurring at the beginning of the project.
Operating Cash Flow (OCF):
It is estimated after-tax cash flow due to the project during its operating life-time. These cash flow generally vary from year to year. Conservatively, the operating cash flows are taken at the end of a year. First the accounting income is calculated by subtracting depreciation for tax purposes. Taxes are deducted from this income. Depreciation is added back to get Net Operating Cash Flow for that accounting period. For a replacement project incremental analysis can be done. Everything has to be calculated on an incremental basis.
Terminal Cash Flow (TCF):
It is the cash flow when the project is terminated. The TCF will be the salvage value of the project and the recovery of the working capital employed.
All these cash flows have to be discounted to find out the net present value (NPV).
Cash flows due to financing activities are implicit in the discounting rate used for finding NPV and are not relevant for decision making purposes.
For selecting the best investment option future cash flow from the project are estimated and analyzed.
Relevant Cash Flow:
For decision making only incremental cash flow analysis is sufficient.
Sunk Cost is irrelevant for decision making purposes.
Opportunity Cost is relevant.
The cash flow as a result of undertaking a project can be divided into three components:
Initial Cash Flow
Operating Cash Flow
Terminal Cash Flow
Initial Cash Flow (ICF):
Cash flow in acquiring new assets/ initial investment for project. It includes cost of the machines and its shipping and installation, testing etc. For using an already owned asset the opportunity cost of the asset has to be added to cash outflow.
From this we have to subtract the after tax proceeds from the sale of old assets.
Initial cash flow also includes cash flow due to change in net working capital (NWC). Net Working Capital = Current Assets - Current Liabilities. Increase in NWC means cash outflow. Change in NWC is not tax deductible.
All these cash flows are assumed to be occurring at the beginning of the project.
Operating Cash Flow (OCF):
It is estimated after-tax cash flow due to the project during its operating life-time. These cash flow generally vary from year to year. Conservatively, the operating cash flows are taken at the end of a year. First the accounting income is calculated by subtracting depreciation for tax purposes. Taxes are deducted from this income. Depreciation is added back to get Net Operating Cash Flow for that accounting period. For a replacement project incremental analysis can be done. Everything has to be calculated on an incremental basis.
Terminal Cash Flow (TCF):
It is the cash flow when the project is terminated. The TCF will be the salvage value of the project and the recovery of the working capital employed.
All these cash flows have to be discounted to find out the net present value (NPV).
Cash flows due to financing activities are implicit in the discounting rate used for finding NPV and are not relevant for decision making purposes.
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