Capital Budgeting : Cash Flow Components

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.

Capital Budgeting

This Article tells us about what Capital Budgeting is and what are the various methods used to evaluate projects.

Capital Investment is spending on long-lived assets.
Capital Budgeting is choosing which project to put money. Its not just choosing best project. It involves identifying potential projects, choosing best out of alternatives and implementing it.

Key parameter for decision making:

1. Simplicity of method of arriving at decision
2. Cash Flows from project
3. Accounting for time value of money
4. Risk-return management
5. Stockholder's value

Methods used for decision making:

1) Payback Period: In this method we choose between the projects based on the time taken to recover the initial investment. We choose the project which has the shortest time period.
Limitations with this method is that it does not take into account the time value of money. also, it is not dependent on the initial investment and ignores the cash flow occurring after the payback period

2) Accounting rate of return(ARR): In this method, we find the ratio of accounting profit, i.e. EBIT and average assets. Whichever project has higher ARR, we take that project.
Limitations with this method is that it also ignores time value of money. Moreover, accounting profit is an ambiguous term. It can vary as per the accounting principles followed.

3) Net Present Value(NPV): In this method, we bring all the cash flows to occur in future at the present value.(discounting them using cost of capital) If the net cash flow comes out to be positive, then project is accepted. Project having higher NPV is selected.
Advantage of this method is that it takes into account the time value of money

4) Internal rate of Return(IRR): this is one of the most widely used method. In this we find out the rate or the cost of capital, at which NPV becomes zero. This rate is known as IRR. In normal cases, i.e. positive cash flows occurring in future, if IRR is higher than present cost of capital, project is accepted. Project having higher IRR is selected.
Limitation of this method is that in case, cash flows sign changes, we get multiple values of IRR which creates problem in taking decisions

5) Profitability Index: this is the ratio of present value of cash inflows to cash outflows.