CASH FLOWS

Cash flow
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Relevant cash flows

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Incremental or marginal cash flows

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Cash flows of the firm ‘with’ and

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‘without’ the project

‘Before versus after’ comparisons
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 An important part of the capital budgeting process is the
estimation of the cash flows associated with the proposed
project.

Any new project will cause a change in the firm’s cash

flows. In evaluating an investment proposal, we must
consider these expected changes in the firm’s cash flows
and decide whether or not they add value to the firm.
Successful investment decisions will

increase the shareholders’ wealth

through increased cash flows?

Valuing projects by estimating their net present values (NPV)
of future cash flows is a means of gaining an idea of their
expected addition to shareholder wealth.

Correct identification of the relevant cash flows associated

with an investment project is one of the most important steps
in the calculation of NPV or in the project appraisal.
Cash flow is a very simple concept, although it is
easily confused with accounting profit or income.....

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Cash flows are simply the rupees received and rupees
paid out by the firm at particular points in time.....
The focus of project analysis is on cash flows because
they easily measure the impact upon the firm’s
wealth.

Profit and loss in financial statements do not always

represent the net increase or decrease in cash
flows.
Cash flows occur at different times and these times are
easily identifiable. The timing of flows is particularly
important in project analysis.

Some of the figures in standard financial statements,

such as income statements or profit and loss accounts,
may not have a corresponding cash flow effect for the
same period; some of their actual cash flows may
occur in the future or might already have occurred in
the past. Example?
Example

A sale on credit is recorded as occurring on the

day the transaction takes place while the actual
cash inflow may occur many weeks or months
later.
In order to evaluate a project, the cash flows relevant
to the project have to be identified.

In simple terms, a relevant cash flow is one which will

change (decrease or increase) the firm’s overall cash
flow as a direct result of the decision to accept the
project.
Relevant cash flows thus deal with changes or increments to
the firm’s existing cash flows. These flows are also known as
incremental or marginal cash flows.
Incremental cash flows are the cash inflows and outflows
traceable to a given project, which would disappear if the
project disappeared.

The incremental cash flows can be measured by comparing

the cash flows of the firm ‘with’ the project and the cash flows
of the firm ‘without’ the project.
Erroneous comparisons such as ‘before versus after’
should be avoided.

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Example suppose a new manufacturing plant uses land
that could otherwise be sold for INR 500,000.

The firm owns the land ‘before’ the project and the firm
still owns the land ‘after’ the project.

Therefore, if a ‘before versus after’ comparison is used,

the cash flow attributed to the manufacturing project will be
zero.
However, the land is a valuable resource
and it is not free !!!
It has an opportunity cost which is the cash it could generate
for the firm if the project were rejected and the land sold or put
to some other productive use.

Therefore, ‘without’ the project, the firm could generate INR

500,000 cash if the land is sold (and some other amount if the
land is put to some other use). ‘With’ the project, the firm
would not be able to generate this cash inflow.

Therefore, INR 500,000 is assigned to the proposed

manufacturing project as a cash outflow.