Essay Paper on Cash Flow

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. Cash flows are simply the dollars received and dollars paid out by the firm at particular points in time. Cash flows are important 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. For 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 business, 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 flow.

Business evaluation rests upon incremental 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. For analytical purposes business cash flows may be separated into two categories: capital cash flows and operating cash flows. Capital cash flows may be disaggregated into three groups: (1) the initial investment (2) additional ‘middle-way’ investments such as upgrades and increases in working capital investments, and (3) terminal flows. These are all cash flows and the distinctions among them are only to facilitate the convenient identification of the different categories.

The largest single capital flow is traditionally the initial investment. This is also called the ‘initial capital outlay’ or just ‘capital expenditure’. Initial capital outlay generally involves the cash outflows required to start a project by purchasing or creating assets and putting them into working order. As such, the necessary expenditures to establish sufficient working capital for the project and the installation costs of the machines purchased are included in the initial capital outlay. The word ‘initial’ is quite important. It denotes both the amount to ‘initiate’ or ‘start’ the project, and the time at which this outlay occurs. Once the initial investment is made and the project is in operation, the project is expected to generate cash flows over its economic life. These flows are called operating cash flows and include: cash inflows from sales, cash outflows for advertising and marketing, payments for wages, heating and lighting bills, and purchases of raw materials…

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