BASIC PRINCIPLES FOR MEASURING PROJECT CASH FLOWS

INCREMENTAL PRINCIPLE: Cash flows must be measured in incremental terms.

1. Consider all incidental effects: Incidental effects on the company’s other operations must be considered.

2. Ignore sunk costs: Outlay incurred in the past or expenses already committed irrevocably should not be considered.

3. Include Opportunity costs: Opportunity cost for diversion of available resources to the project should be included.

4. Allocation of overheads: Overhead costs not relevant to the project should not be included.

LONG TERM FUNDS PRINCIPLE: It is recommended that the project should be evaluated from the Long-Term Funds point of view as the principle focus of financial appraisal is on profitability of long term funds.

EXCLUSION OF FINANCING COSTS PRINCIPLE: Financing costs of the long-term funds should be excluded from analysis. (Interest on long term funds to be added back to profits after tax)

POST-TAX PRINCIPLE: All cash flows to be defined in post tax terms since the cost of capital is considered on post tax basis.

COMPONENTS OF CASH FLOW STREAM

1. INITIAL INVESTMENT: Capital Assets, Installation Costs, Working Capital Margin, Preliminary & Pre-operative expenses.

2. OPERATING CASH INFLOWS: Profit after tax, Depreciation add back, other non-cash charges, long term loans interest X (1-t)

3. TERMINAL CASH FLOW: Salvage value of fixed assets (post-tax), recovery of working capital margin.