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One of the most important tasks in capital budgeting is the calculation of future cash flows of a project. The final results we obtain are only as good as the accuracy of our estimates. Since cash, not revenue, is fundamental to all decisions of the corporation, we express any benefit we expect from a project in terms of cash flows rather than income.
The organization invests cash now in the hope of receiving more cash returns in the future. Only cash income can be reinvested in the company or paid to shareholders in the form of dividends. In the capital budgeting, good employees can get credit, but the effective managers are those who receive the money. When trying to establish the cash flows for your analysis, a computer spreadsheet program is an invaluable instrument. It allows one to change assumptions and quickly produce a new series or stream of cash flows.
INCREMENTAL CASH FLOWS
For each investment proposal, we need to provide information about the expected future cash flows with a basis after taxes. In addition, information must be provided on an incremental basis, so that we analyze only the difference between the company’s cash flows with the project and without it. For example, if a company is considering a new product that is likely to compete with existing products, it is not appropriate to express the cash flows in terms of the calculated sales of the new product. We must take into account any probable “cannibalization” of existing products, and we must prepare our cash flow estimates based on incremental sales. The key is to analyze the situation with the new investment and without it. Only incremental cash flows are important.
Pass Through Hundred Costs
In this respect, the sunk costs must be ignored. One is concerned with incremental costs and benefits: the recovery of past costs is irrelevant. They are things that have gone and that should not enter the decision process. Also, we must bear in mind that certain costs do not necessarily involve an outflow of money. If we have allocated space in the plant for a project and this space can be used for something else, its opportunity cost should be included in the evaluation of the project. If a building that currently is not in use can be sold for $ 300000, that amount should be taken as an expense in cash at the beginning of the project. In this way, when deriving cash flows we must take into account the appropriate opportunity costs.
Cash flows include labor and maintenance costs, materials and other miscellaneous expenses associated with the product. Like sales, these costs must be calculated on an incremental basis. In addition to these outputs, the organization will need to pay higher taxes if the new product generates higher profits, and this incremental disbursement must be included. Cash outflows 110 should include interest costs on the debt used to finance the project. These costs are incorporated in the required rates of return. The deduction of interest charges from net cash flows would result in double counting.