Easy Notes - By Manoj Singh

Basic principles which should be kept in mind while calculating cash flows are mentioned below.

1. Incremental approach

While calculating cash flows, only those cash flows are considered which can be associated and attributed to adoption of a particular project. Finance manager should check for nature of expenses very wisely while evaluating proposals. Only incremental cash flows are considered for capital budgeting.

2. Financial cash flows 

As cost of debt or equity is already considered in WACC (weighted average cost of capital) which is used for discounting cash flows, financial cash flows are ignored in order to avoid error of double counting,

3. Cash flows are considered on after tax basis. Tax savings is considered as an inflow.

4. Depreciation is added back to PAT as they are of non-cash nature and provides a tax shield i.e. reduction in tax liability. All non-cash items should be added back to PAT to arrive at cash inflows.

5. Sunk cost is ignored as these are not incremental.

Sunk costs are that cost which has already been incurred in past, prior to evaluation of proposals and is thus ignored as this doesn't have effect on present or future decisions. Example, if a company has piece of land acquired in past and is considering to set up a plant on that land, then this cost land acquisition in past is considered as sunk cost.

If a new land has to be acquired for this new project then the cash outflows should be considered in capital budgeting.

6. Opportunity costs are considered as they are sacrificed. Opportunity costs of a resource is its value in its best alternative usage.

7. Unless given otherwise, it is assumed that cash outflows are considered to have occurred in the beginning of the year and inflows to be occurred at the end of the year.

8. While evaluating replacement decision, savings in costs are always considered as inflows and that to on after tax basis.

Calculation 

Cash inflows

PAT (Profit after tax) + Depreciation +Financial charge (1-tax rate) – Capital expenditure (if any) – Repairs (if any)

Where,

PAT is calculated as

Net sales revenue – Cost of goods sold – Selling, general & administration expenses – Depreciation – Interest – Taxes

Where,

Cost of goods sold is calculated as

Opening inventory + Purchases – Closing Inventory

Cash outflows

Cost of new plant + Installation expenses + Other capital expenditure + Additional working capital – Tax benefit on account of capital loss on sale of old plant (if any) – Salvage value of old plant + Tax liability on account of capital gain on sale of plant (if any)

If we talk about the global scenario, 

Under non – discounted cash flow category: Payback period is the most popular technique used worldwide.

Under discounted cash flow category: NPV (Net present value) & IRR (Internal rate of return) are the most popular methods.

Please have a look at the chart which shows the ranks of capital budgeting techniques based upon preference of respondents on a scale of 0 (never) to 4 (always) in 4 countries such as USA, UK, Germany & France. 

Source: As per report published by Graham & Harvey Surveys (2001) & Brownen, Dejong & Koedijk Survey report (2004) 

Below mentioned findings were further highlighted by similar surveys.

1. In European countries, most of the companies prefer Payback period method for making capital budgeting decisions.

2. In USA, IRR is still the favourite while taking decisions. Thereafter, NPV & Payback period is considered.

3. Companies managed by MBA degree holders have a strong preference for discounted cash flow techniques such as NPV / IRR.

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