Understanding Cash Inflow Calculation

A Comprehensive Guide to Cash Flow Analysis for Project Evaluation
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  • Cash Flow

Cash inflow forms the foundation of any project evaluation. The basic formula for calculating operating cash inflow is:

Cash Inflow = PBIT + Non-cash expenses

Where PBIT stands for Profit Before Interest and Taxes. The most common non-cash expense is depreciation. This gives us:

Cash Inflow = PBIT + Depreciation

Calculating Depreciation

Depreciation per annum is typically calculated using the straight-line method:

Annual Depreciation = (Cost of Project - Scrap Value) / Useful Life of Project (years)

This depreciation amount is subtracted when calculating PBIT but added back when determining actual cash flow since it doesn't represent a real cash outflow.

Initial Capital Cost Components

The initial capital cost of a project includes:

  1. Cost of New Assets: The purchase price of equipment, machinery, buildings, or other tangible assets required for the project.

  2. Net Book Value of Existing Assets: If existing assets are repurposed for the new project, their current book value (original cost minus accumulated depreciation) should be considered.

  3. Investment in Working Capital: The additional inventory, accounts receivable, and other current assets needed to support operations, minus any increase in accounts payable and other current liabilities.

  4. Capitalized R&D Expenses: Research and development costs that are capitalized and amortized against future profits rather than expensed immediately.

Principles of Cash Flow Analysis

Types of Cash Flows to Consider

  1. Future Cash Flows: Only future cash flows are relevant for decision-making.

  2. Incremental Cash Flows: Only the differential cash flows that occur as a direct result of accepting the project should be considered.

  3. Cash-Based Analysis: Focus on actual cash movements, not accounting profits.

  4. Opportunity Costs: The value of the best alternative foregone should be included as a cost.

Cash Flows to Exclude

  1. Sunk Costs: Past expenditures that cannot be recovered regardless of the decision should be ignored.

  2. Committed Costs: Costs that are already obligated and cannot be avoided should be excluded unless they differ between alternatives.

  3. Non-Cash Items: Accounting entries like depreciation and amortization don't represent actual cash flows (though they affect taxes, which do involve cash).

  4. Allocated Costs: Arbitrary allocations of existing overhead costs should be excluded unless the project truly causes an increase in these costs.

Practical Application

Let's illustrate with a simplified example:

Suppose a company is considering a new production line with:

  • Equipment cost: $500,000
  • Expected useful life: 5 years
  • Estimated scrap value: $50,000
  • Additional working capital needed: $100,000
  • Capitalized R&D: $75,000 (to be amortized over 5 years)

Step 1: Calculate initial capital cost 

Initial Capital Cost = $500,000 (equipment) + $100,000 (working capital) + $75,000 (capitalized R&D)
                     = $675,000

Step 2: Calculate annual depreciation 

Annual Depreciation = ($500,000 - $50,000) / 5 years = $90,000

Step 3: Calculate annual cash inflow Assuming the project generates PBIT of $150,000 per year:

Cash Inflow = $150,000 (PBIT) + $90,000 (depreciation) = $240,000

This doesn't include tax effects, which would further modify the cash flow.

Common Pitfalls in Cash Flow Analysis

  1. Including Financing Costs: Interest payments should be excluded from operating cash flows when using discounted cash flow methods like NPV or IRR.

  2. Ignoring Opportunity Costs: Failing to account for the value of resources in their next best alternative use.

  3. Including Sunk Costs: Considering past expenditures that cannot be recovered.

  4. Double Counting: Including both depreciation and the full cost of an asset.

  5. Overlooking Working Capital Recovery: Forgetting that working capital is typically recovered at the end of a project.

Conclusion

Proper cash flow analysis is critical for making sound investment decisions. By focusing on relevant cash flows—future, incremental, and cash-based—and properly accounting for opportunity costs while excluding sunk costs, committed costs, non-cash items, and irrelevant allocated costs, you can develop a robust framework for evaluating projects.

Remember that the ultimate goal is to determine the true economic impact of a project on the organization's value, which depends entirely on its effect on cash flows.

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