Cash Flow Estimation & Their Types

Cash flow estimation

Cash flow estimation is a must for assessing the investment decisions of any kind. To evaluate these investment decisions there are some principles of cash flow estimation. In any kind of project, planning the outputs properly is an important task. At the same time, the profits from the project should also be very clear to arrange finances in a proper way. These forecastings are some of the most difficult steps involved in the capital budgeting. These are very important in the major projects because any kind of fault in the calculations would result in huge problems. The project cash flows consider almost every kind of inflows of cash. The capital budgeting is done through the coordination of a wide range of professionals who are going to be involved in the project. The engineering departments are responsible for the forecasting of the capital outlays. On the other hand, there are the people from the production team who are responsible for calculating the operational cost. The marketing team is also involved in the process and they are responsible for forecasting the revenue. Next comes the financial manager who is responsible to collect all the data from the related departments. On the other hand, the finance manager has the responsibility of using the set of norms for better estimation. One of these norms uses the principles of cash flow estimation for the process. There are a number of principles of cash flow estimation. These are the consistency principle, separation principle, post-tax principle and incremental principle. The separation principle holds that the project cash flows can be divided in two types named as financing side and investment side. On the other hand, there is the consistency principle. According to this principle, some kind consistency is necessary to be maintained between the flow of cash in a project and the rates of discount that are applicable on the cash flows. At the same time, there is the post-tax principle that holds that the forecast of cash flows for any project should be done through the after-tax method.

Separation Principle The Separation Principle is used to bring out the project cash flows of a particular project. It is an important part of capital budgeting. Before starting a new project, it is very important to estimate properly the inflow and outflow of cash. There are several methods that are used to bring out the exact figure of the project cash flow and Separation Principle is one of those methods. The Separation Principle treats the cash flow in a different way. At first, the project is divided in two parts. The first part deals with the investment side and the later part is related to the financing side. To get proper picture of the project cash flow, the cash flow is separated according to its relation with the investment of financing side. There are several unique features of Separation Principle. One of these features is that the cash flow related to the investment side of the project never considers the cost of financing. On the other hand, these charges of financing are considered while the cash flow calculations related to the financing side are done. These charges of financing are indicated through the charges of capital figure. The calculations of the returns related to the investment side are based on the hurdle rate that is the capital cost. Another important feature of separation principle is that the interest rates on the debt securities are excluded at the time of calculating the profits and payable taxes. Now, according to this theory, while bringing out the profit, if the applicable interest is subtracted, the same amount should be added to the profit that remains after paying the applicable tax. On the other hand, if the tax rate is imposed directly on the profit (from which interest and taxes are not adjusted) the results are not going to differ.

Incremental Principle The incremental principle is used to measure the profit potential of a project. According to this theory, a project is sound if it increases total profit more than total cost. To have a proper estimation of profit potential by application of the incremental principle, several guidelines should be maintained: Incidental Effects: Any kind of project taken by a company remains related to the other activities of the firm. Because of this, the particular project influences all the other activities carried out, either negatively or positively. It can increase the profits for the firm or it may cause losses. These incidental effects must be considered. Sunk Costs: These costs should not be considered. Sunk costs represent an expenditure done by the firm in the past. These expenditures are not related with any particular project. These costs denote all those expenditures that are done for the preliminary work related to the project, unrecoverable in any case. Overhead Cost: All the costs that are not related directly with a service but have indirect influences are considered as overhead charges. There are the legal and administrative expenses, rentals and many more. Whenever a company takes a new project, these costs are assigned. Working Capital: Proper estimation is essential and should be considered at the time when the budget for the project's profit potential is prepared.

Consistency Principle

Consistency Principle is one of the four major principles that are used for estimating the project cash flows. According to this principle, consistency in the cash flows is very necessary. At the same time, consistency in the applicable discount rates on the cash flows should also be maintained. There are two important factors that are related to the Consistency Principle. These two are the investor group and the inflation. Investor Group: The Consistency Principle holds that while estimating the project cash flow, it is also important to consider the investor's opinion or view. There are different types of investors in a firm like the lenders or the stockholders and so on. Again, if it is not possible to consider every kind of investors' view, then the stockholder's view regarding the cash flow may be considered. According to the investor's standpoint, the project cash flow denotes that amount of cash that is provided to the investors. The payable taxes must be deducted from this amount and if there is any need for investment in the ongoing project then that amount should also be deducted from the amount allotted for the investors. At the same time, if the stockholders standpoint is regarded then the project cash flow is that amount that is offered to the stockholders. This amount should not include any kind of payable tax or any such amount that is necessary to invest in the particular project. Again, before offering any money to the stockholders, the firm is required to clear all the debts. Now, the next important factor is the consistency of the discount rate that is to be applied on the project cash flow. There are two types of discount rate known as the weighted average cost of capital and cost of equity. Inflation: In case of inflation, there are two ways of estimating the project cash flow of a particular project. The first option is to merge a likely inflation in the project cash flow estimates. After this, a nominal discount rate is applied on the amount. Another way of handling the inflation factor is to calculate the project cash flows of the future in real terms with real discount rates.

Post Tax Principle Post Tax Principle is one of the basic principles of cash flow estimation. This is used to bring out the project cash flows with accuracy. After tax calculations are suggested by the Post Tax Principle for the project cash flow. There are some businesses that generally neglect the payment of tax while measuring the cash flow of a project. Next, these businesses try to cover the fault by using the discount rate. These discount rates are very hard to adjust and thus the after-tax rate of discount and after-tax cash flows are used jointly. There are some important issues that are related to the Post Tax Principle and its application. These issues are the following: Tax Rate: There are two different tax rates termed as the average tax rate and the marginal tax rate. The average tax rate is considered as the entire tax as a proposal of the overall earning from the business. On the other hand, the marginal tax rate represents those taxes that are imposed on the earnings at margin. The tax rates are often found as progressive and because of this, the average tax rates are always lower than the marginal tax rate. The firms run some particular projects and the income from these projects are considered as marginal because this income is a kind of additional income as the existing assets of the firm are the main source of income. Because of this, the payable taxes on the project are estimated through the marginal tax rate, as it is the most appropriate rate to do that. Handling the Losses: The post tax principle holds that there remains possibility of losses for both the firm as well as the particular project. There are several ways of minimizing these losses. In certain situations, the tax saving is postponed until the firm or the particular project makes profit. Non-Cash Charges: The post tax principle also holds that whenever the tax liabilities are affected by the non-cash charges, the project cash flow estimation will be affected. Depreciation is one of these non-cash charges.