Prima facie, capital budgeting may seem like a very simple task.
After all, it has just 3 steps. The first is to find the cash flows, the second is to find the appropriate discount rate that represents the time value and riskiness of those cash flows and the third step is to use both these inputs and discount the cash flows at the chosen rate. However, in practice it is not that straightforward.
There are many complications that arise during the process. Complications usually arise because neither of the variables that we are using in the projection is certain. We are therefore, at best choosing estimates. Deciding whether we have the right estimates is very important.
A slight change could bring about a completely different valuation. In this article, we will first see how we can derive cash flows from accounting profits and then we shall have a closer look at some of the complications that may arise in the process of estimating cash flows. Capital budgeting is completely dependent upon cash flows. It is not concerned with the accounting profits of a project.
Yet, most of the times analysts will have financial statements that talk about the accounting profit. So, they have to derive the cash flows from the accounting profit. This can be done by undoing the two adjustments that accountants make to come at the profit:. Accountants count income in the period it is earned.
As opposed to this, cash flow needs to be accounted for in the period that it was received. Hence the numbers need to be adjusted.
Estimating Project Cash Flows 1 pptx
Also, accountants segregate the cash outflows into expenses and asset creation. So once again, this assumption also needs to be undone while computing the cash flows that need to be discounted.
Secondly, it is important to consider each project as a separate investment and we must consider only the incremental cash flows that arise as a result of this investment decision.
The key is to consider the value of your firm with and without the investment. The idea is to look at both possible scenarios and decide which one we want to be in. This part can be counter-intuitive for many people.
But remember that we are only considered with the additional dollars that we will make as a result of this investment. Why should we consider what we are already earning from past projects into consideration to decide whether or not we should invest in the next one?
Also, it is important to consider the incidental effects of some projects.
In theory, projects work in isolation. But we know for a fact that in reality that is not the case. The fate of many projects is usually interconnected.
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