IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 4. Why do we use a cash flow analysis instead of a profit analysis in a capital budgeting decision? What are the general principles of cash flow estimation?

Ans. Principles of cash flow estimation

In this part we are going to see, how a capital budgeting decision is to be made and what are the principles that must be observed in order to make an estimation of cash flows in a scientific manner. As pointed out in previous section all estimates of receipts and payments should be based on cash flow rather than on revenue and expenditure or profit and loss. The reason is that cash flows are very certain amounts and are not subject to different interpretation by different people. Accrual principle is considered better for the purpose of accounting, (probably because it calculates profit or loss for a given year), but for a long term investment decision making cash principle will be better. Every payment of cash, for whatever purpose, is an outflow, while every receipt of cash, for whatever reason is an inflow. Any non cash expenditure (like depreciation) will not be accounted for because it does not involve any cash outflow. The following principle should be adhered to in estimating cashflows in respect of a project.

1. All calculation of cash flows should be done on incremental basis rather than on aggregate basis. If any inflow is in addition to the exiting inflows, it should be accounted for otherwise not. If a machine costs Rs. 1,00,000 and it replaces an old machine which has fetched Rs. 20,000, then the cash outflow should be taken as only Rs. 80,000, even if the cost of machine is Rs. 1,00,000.

2. Cash flow should be taken on ‘After-tax’ basis. Each income of a company is subject to corporate income tax. So the amount of tax is cash outflow even if we may not consider it as expenditure. Hence, if we have to find out net cash inflow the amount of tax paid should be subtracted and ‘cash flow after tax ‘(CFATs) should be calculated.

3. Sunk- costs should be ignored. The costs which have already been incurred and which are non recoverable should not be taken into account while calculating cash outflows for a period. This is because no net cash flows are taking place on account of a particular decision (since they have already been incurred and can’t be recouped).

 4. Calculation of cash flows should also take into account the opportunity cost even if no actual cash inflow or outflow takes place. For example, if we are using our own premises for a particular project, then possible rental should be taken as the cash outflow while making our calculations. This is because in making our decision we are foregoing this income and this should be regarded as a cost.

5. A very important aspect of cash flow calculation is that cash flows on account of interest payments are not to be considered while making the calculation of cash flows. This may look odd, because the interest payment is an actual outflow and ignoring it may appear to be incorrect. However, it must be understood that the discounting of cash flows for their time value automatically takes into account the interest cost of any investment. Therefore, subtracting interest payment and then discounting it for time value will lead to double counting. Rate of interest is a compensation for time value of money and when we discount some cash flows for their time value at the given rate of interest, there is no need to subtract interest payments separately.

6. Cash needs for working capital should be treated as a cash outflow at the time of commencement of a project and should be treated as inflows when that cash is released at the time of closure or termination of project. Increases or decreases of working capital should be treated as outflows and inflows respectively as and when they take place.