Lesson 1, Topic 1
In Progress

Project cash flows

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The most common cash outlays considered in the capital budgeting decision are:

  • the initial cost of the investment
  • incremental operating costs needed for the investment
  • maintenance and repairs associated with the investment
  • any increase in working capital required to support the investment.

Typical cash inflows associated with the investment decision are:

  • incremental revenues from the investment
  • resulting cost reductions
  • revenues gained from the disposal of the asset or, alternatively, any residual value at the end of the asset’s useful life if there is no disposal of the asset
  • any decrease in working capital that may occur during or at the end of the asset’s life.

Note that accounting ‘depreciation’ does not involve a cash outlay when it is recorded in the accounts each year so it must not be included as a cash flow for financial analysis purposes. The true depreciation of our project is represented by the difference between our initial capital outlay for the project minus the disposal value or the residual value at the end of the cash flow period used for the analysis.

The basic concept of the time value of money is that a dollar held today is worth more than a dollar at any time in the future. The ‘time value’ of money can be considered in terms of either the ‘future’ value of current cash flows, or the ‘present’ value of future cash flows, as illustrated in Figure 5-1. The money we hold today can be invested to earn interest and any principal invested will grow in time.

For example, $100 invested today at 10% interest compounded annually (i.e. the interest is calculated only once a year) will become $110 one year later, i.e. $100 plus 10% of $100. In reverse, we can say that $110 in one year’s time is only worth $100 today. The $110 is the ‘future value’ (FV) of $100 today because of the interest earned for one year. Conversely $100 is the ‘present value’ (PV) of $110 that is available to us in one year. The process of converting a ‘future value’ to the ‘present value’ is termed discounting. The term ‘discount rate’ is used to indicate that a present value is being calculated, rather than a future value.

NOTE: Do not be daunted by the mathematics of discounted cash flows. These are handled easily by any computer-based spreadsheet. For this course, you are not expected to carry out complicated mathematical calculations.