Evaluating the net cash flow is crucial when analyzing the viability of a particular investment project. The net cash flow refers to the total cash inflows minus the total cash outflows of a project over its lifetime. It factors in the initial investment, operating costs, depreciation, taxes, changes in working capital and salvage value. A positive net cash flow means the project is profitable. There should be thorough financial modeling and forecasting during the project evaluation phase to determine the incremental net cash flows arising from undertaking the project. Terms like stand-alone principle, opportunity costs, sunk costs and erosion effects need to be considered when determining which cash flows are truly incremental. Investment projects with higher, more stable net cash flows have lower risk and greater viability. Multiple valuation techniques like NPV, IRR and Payback Period should then be used on the net cash flows to make the final capital budgeting decision.
Identifying the relevant net cash flows from a proposed investment project
The first step is to identify which cash flows are incremental and directly attributable to the project, thus forming its net cash flow. We employ the stand-alone principle to evaluate project cash flows independently. Cash flows like sunk costs that have already occurred, opportunity costs that involve loss of another option’s benefits, as well as any financing costs like interest should all be ignored. Special attention must be given to changes in net working capital over the project lifespan. Additional investments in inventory, receivables and cash buffers to support the project need to be tracked as part of the initial cash outlay. Release of working capital at the end also constitutes a cash inflow.
Accounting for side effects and business erosion
The introduction of a new product or expansion project can negatively impact sales of existing products due to competition. Lower revenues from existing products must be included in net cash flows. On the flip side, positive spillovers like increased consumable sales for printers will increase cash inflows. Business erosion and side effects have a material impact on incremental net cash flows.
Estimating net cash flows by forecasting components
Future cash flows must be estimated via financial modeling and forecasting of individual components. The initial outlay and any changes in working capital constitute cash outflows. Cash inflows mainly come from projected profits adjusted for non-cash items like depreciation. Depreciation lowers tax, so the tax-shield provided is included in net cash inflows. The recovery of working capital and salvage value at the project end will also provide cash inflows.
Using valuation models like NPV and IRR on net cash flows
Once net cash flows have been estimated, they can be used as inputs to various capital budgeting models. NPV uses discounted net cash flows and targets positive NPV projects. IRR determines the breakeven rate of return. Payback Period calculates duration to recover initial investment. The attractiveness of investment projects can be compared based on these valuation outputs calculated using net project cash flows.
Estimating the net cash flow is thus essential when evaluating investment projects to determine viability and accept/reject decisions. All relevant cash inflows and outflows over the asset lifespan need to be forecasted. Side effects eroding existing product incomes must be considered alongside new project revenues. Various valuation models can then help assess project returns and risks.