Chapter 2: Project CashFlowsThe definition, identification, andmeasurement of cash flowsrelevant to project evaluation. 1
Why Cash Flows? Cash flows, and not accounting estimates, are used in project analysis because:-1. They measure actual economic wealth.2. They occur at identifiable time points.3. They have identifiable directional flow.4. They are free of accountingdefinitional problems. 2
The Meaning of RELEVANTCash Flows.A relevant cash flow is one which will change as a direct result of the decision about a project. A relevant cash flow is one which will occur in the future. A cash flowincurred in the past is irrelevant. It issunk. A relevant cash flow is the difference in the firm’s cash flows with the project, and without the project. 3
Cash Flows: A Rose By AnyOther Name Is Just as Sweet. Relevantcash flows are also known as:- Marginal cash flows. Incremental cash flows. Changing cash flows. Project cash flows. 4
Project Cash Flows:Yes and No. YES:- these are relevant cash flows - Incremental future sales revenue. Incremental future production costs. Incremental initial outlay. Incremental future salvage value. Incremental working capital outlay. Incremental future taxes. 5
Project Cash Flows:Yes and No. NO:- these are not relevant cash flows - Changed future depreciation. Reallocated overhead costs. Adjusted future accounting profit. The cost of unused idle capacity. Outlays incurred in the past. 6
Cash Flows and Depreciation:Always A Problem. Depreciation is NOT a cash flow.Depreciation is simply the accountingamortization of an initial capital cost.Depreciation amounts are onlyaccounting journal entries. Depreciation is measured in project analysis only because it reduces taxes. 7
Other Cash Flow Issues. Tax payable: if the project changes tax liabilities, those changed taxes are a flow of the project. Investment allowance: if a taxingauthority offers this ‘extra depreciation’concession, then its tax savings areincluded. Financing flows: interest paid ondebt, and dividends paid on equity, areNOT cash flows of the project. 8
Other Cash Flow Issues. In property investment, ‘property’ cash flows may be distinguished from ‘equity’ cash flows. In project analysis, cash inflowsare timed as at the end of a year, andcapital outlays are timed as at thestart of a year. Forecast inflated cash flows must bediscounted at the nominal discountrate, not the real discount rate. 9
Using Cash Flows All relevant project cash flows are setout in a table. The cash flow table usually readsacross in End Of Years, starting at EOY 0(now) and ending at the project’s lastyear.The cash flow table usually reads downin cash flow elements, resulting in a NetAnnual Cash Flow. This flow will have apositive or negative sign. 10
Project Cash Flows: SummaryOnly future, incremental, cash flowsare Relevant. Relevant Cash Flows are enteredinto a yearly cash flow table. Net Annual Cash Flows arediscounted to give the project’s NetPresent Value. 11
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