Cash flows and measures of investment worth

Investment generates cash outflows and cash inflows over time. The former are partly non-recurring and partly recurring, while the latter are of the recurring variety only. The non-recurring cash outflows consist of expenditures on land, buildings, plant and machinery, technical know-how fees, etc., and these are committed until the project is commissioned. The recurring cash outflows include expenses on wages and salaries, raw materials, electricity. Telephones, promotional activities, etc., and these are incurred year after year from the day the project is commissioned until the day the project is wound up. Besides these costs, there are interest cost, depreciation cost, taxes and subsidies. In addition there are externalities the side effects of economic activities which could be beneficial as well as harmful. The beneficial externalities include improvements in the environment, which are off shoots of activities such as construction of dams, gardens, swimming pools, etc. The harmful externalities consist of air and water pollution, which results from activities leading to throwing of smokes and waste (e.g. textile mills), traffic congestion (caused by, say, establishing a factory in the heart of a city), accident hazards (such as the one caused by Union Carbide in Bhopal), etc.

The cash inflows essentially comprise of the sales of basic and by-products which take place year after year and of the salvage or scrap value of the project which is realized when the project is sold out. Incidentally note that while estimating the cash outflows and cash inflows from an investment project, care must be taken to truly identifying these flows which are the result of the project per se. An investment need not be an altogether new activity and if it were in the form of a replacement investment or an investment resulting into multiplication of capacity in the old product line etc then there will be cash flows both in the absence of such an investment as well as in the presence of it. In that case, the analyst must attribute only the net cash flows to the project, which consists of the difference between cash flows with the project and those without the project, and not the difference between cash flows after the project and before the project. This is because such projects generate cash flows even if the additional investment is not undertaken.

Since money has time value, all cash outflows and cash inflows must be recorded by the time of their occurrence. Of course, time even by day is relevant in this context, but for the sake of simplicity it is customary to treat the year as a unit of time in capital budgeting. Such an assumption does not lead to too much of distortion, for the time value of money for periods less than a year is not usually very significant. In view of this, we shall follow the tradition of treating the year as a unit of time while adjusting for the time value of money. For the similar reasoning, the compounding and discounting would be assumed to be done once in a year.

A project would thus have expected cash outflows and cash inflows, recorded on a yearly basis spread over its life time. In the beginning, until the project is commissioned into production, there would be cash outflows only but later on both outflows and inflows would co-exist and inflows normally exceed the outflows. If we treat outflows as negative and inflows as positive, and convert these into net cash inflows (NCI), there would be negative NCI in the beginning and positive NCI later on. Thus, an investment project with two years of gestation period and seven years of productive life would generate NCI of the following type:
(Rs. Lakh)
Year : 1987 1988 1989 1990 1991 1992 1993 1994 1995

NCI : – 100 -200 -10 20 50 100 100 100 150

In this example , the project implementation starts in 1987, when expenditure is incurred on technical known-how, purchase of land, construction of buildings purchases of plant and machinery, etc., all of which is not complete in the first year but spills over to the following year as well. In beginning of the third year, the project is ready for commercial production and starts yielding cash inflows. As one would normally expect, it takes a few years for the project to mature in terms of the optimum capacity utilization. In the above example, capacity utilization is considered to be limited in the first three years of operation after which it goes to the optimum level. In the last year of the project life, the project yields cash inflows not only through sales but also through its scrap value, which consists of the market value of its assets and goodwill, if any.

In the above project, the capital cost is Rs. 300 lakhs, if the time value of money is ignored. It is customary to estimate the project cost as on completion, giving due consideration to the time value of money. Thus, under the compound rate of 20%, the project cost equals rupees.

100(1 + 0.20) + 200 = 320

From 1989 the project generates cash inflows in terms of sales, and cash outflows in terms of recurring costs of wages, raw materials, etc. The NCI during 1989 through 1995 represents the year wise difference between such cash inflows and cash outflows.

The investor or the analyst would need to examine the viability of this project per se and in relation to alternative projects available to him. In other words, there is a need accept-reject decision and ranking decision with regard to each alternative project. Obviously such decisions depend on the objective of the investor, among other things. Most investors aim at maximizing the value of their firm, which is tantamount to the maximization of the return on investment (ROI).