Project Cash Flow: Analysis & Examples

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  • 0:03 What Are Relevant Cash Flows?
  • 1:13 Examining Relevant Cash Flows
  • 5:06 Stand Alone Principle
  • 5:38 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

When a company is considering a new project or investment, it must have some method to evaluate whether to proceed. In this lesson, you'll learn how relevant cash flows can help with this decision.

What Are Relevant Cash Flows?

Investing in a new project requires cash, and a company must decide whether the project will be a good use of its cash. In other words, is the project going to generate enough cash flow over its lifetime to make the investment worthwhile?

To help with this decision, companies study their relevant cash flows, which are cash flows that will only occur if the company proceeds with the project or investment. Relevant cash flows occur at some point in the future and are incremental. Incremental cash flows are changes in cash flows that occur because a company decided to proceed with an investment. Costs that have already occurred, such as for research and development, will not be relevant to the decision since they occurred in the past. These types of costs are known as sunk costs.

Let's meet Mr. Tater, who owns the Crunchy Spud Potato Chip Company. He has just completed market research that suggests consumers would like chips made from sweet potatoes. To manufacture this new chip, Mr. Tater would have to purchase a new piece of equipment that costs $300,000. He is not sure how to evaluate whether this purchase would be good for his company at the present time. Let's see if we can help Mr. Tater with this decision.

Examining Relevant Cash Flows

We'll start by examining Mr. Tater's relevant cash flows. Remember, relevant cash flows are those that occur in the future, are incremental, and only occur if the project or investment is approved. Examples of relevant cash flows include:

  • Opportunity costs
  • Cash inflows and outflows
  • Terminal amounts
  • Changes in net working capital

Let's examine each of these relevant cash flows individually and see how they apply to Mr. Tater's business.

Opportunity Costs

Opportunity costs represent amounts that are lost by choosing one investment over another. Even though this is not a future cash flow, it must be considered here because choosing to invest in one project may result in losing cash flow from another.

Let's assume that when Mr. Tater starts manufacturing sweet potato chips, he may lose out on $100,000 in additional revenue he could make by devoting all of his manufacturing resources to the types of potato chips he already makes. The $100,000 represents an opportunity cost and is relevant to investment decisions.

Cash Inflows and Outflows

Cash inflows and outflows are incremental cash flows, which you might recall are changes to cash flows that arise from proceeding with an investment or a project. If the investment isn't made, no cash flow would be generated. There are three types of incremental cash flows:

  • Initial cash flows
  • Operating cash flows
  • Terminal cash flows

Initial Cash Flows

Initial cash flows are those that arise from the investment or project. The formula for calculating initial cash flow is:

Initial cash flow = purchase price + delivery + installation + additional investment in working capital

Working capital is the difference between current assets and current liabilities. Assets are items of value that a company owns, and liabilities are items that a company owes, for example debts. To be considered current, these items must be used up or paid within one year. Sometimes when an investment is made, the business will need to purchase more inventory, which will cause a change in working capital. For example, if Mr. Tater goes ahead with the investment, he will have to purchase sweet potatoes. This will increase both his inventory balance and his accounts payable (or the amount that he owes to his suppliers).

Let's calculate initial cash flow for Mr. Tater. The new equipment will cost $300,000, plus delivery fees of $5,000, installation fees of $2,000, and an additional investment of $15,000 in working capital. The initial cash flow for the new equipment would thus be: $300,000 + $5,000 + $2,000 + $15,000, or $322,000.

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