Relevant cash flows of capital budgeting and investment appraisal are one area that confuses people a lot. This confusion is common amongst students that are taking financial management as a course in their bid to become finance professionals.
The motivation for writing this article is to clear this confusion on what is relevant cash flow and what is not relevant cash flow. In this article, you will learn what relevant cash flow is and how to identify relevant cash flow. You will also get explanation to some other questions that bother around relevant cashflow of capital budgeting and investment appraisal.
WHAT ARE RELEVANT CASH FLOWS?
Relevant cash flows are inflow and outflow of cash whose inclusion or exclusion from investment appraisal can affect the overall investment decision. What this means is that finance / funds that have already been committed will not be considered while performing your capital budgeting. Costs like R&D, market research costs, old (redundant) staffs’ salary, etc will not be included as projected cash flow of a project that will be considered for investment analysis purpose. The cost of feasibility studies for instance cannot be considered a relevant cost as the acceptance or rejection of the project will not reverse the cost.
Again, paper costs like depreciation and capitalized costs cannot affect your analysis of businesses and projects. Be sure to identify sunk costs and remove them from your analysis. Sunk costs are costs that have already been incurred without prospect. Understanding the principle behind the timing of cash flows will help you identify which cost is relevant and which one is not relevant. Below are clues on how to properly time your cash flows both for real life purpose and exam purpose.
TIMING OF CASH FLOW
Initial investment, working capital and tax cash flows are the ones that are mostly timed wrongly. The mere fact that meetings and discussions have been had about a project does not mean that any concrete thing has taken place.
Discounted cash flow: by discounted cash flow, we mean investment appraisal technique which takes into account both cash timings of cash flows and streams of cash flow over a projects life span. Discounting is clearly concerned with timing of cash flows. As a general rule, the following guidelines may be applied:
- A cash outlay to be incurred at the beginning of an investment project (‘now’) occurs in year 0. The present value of one dollar ($1) now, in year 0, is 1$ regardless of the value of r (the discount rate).
- A cash flow (inflow and outflow) that occurs during the period is said to all occur at the end of the period- year end. Suppose a company’s year end is November, receipt of $20,000 in March will be said to occur at the end of the year, which is November in this case.
- A cash flow that occurs at the beginning of a period is taken to have occurred at the end of the previous year. This is to say that cash outlay of $15,000 at the beginning of year 2 is taken to have occurred at the end of year one.
Relevant cash flows is the key to any investment appraisal and capital budgeting.
Leave a Reply