Question

The author of Financial Management mentions seven issues that have to be kept track of during a comprehensive cash flow estimation process. Explain the role of each, when estimating cash flow.

Answer 1

Seven issues that have to be kept track of during a comprehensive cash flow estimation process:

1. Sunk costs
2. Opportunity costs,
3. Capital expenditures
4. working capital,
5. Synergy gains,
6. Erosion costs,
7. Depreciation and cost recovery of divested assets

• Sunk costs

Sunk costs are costs already incurred or will be incurred irrespective of the decision to undertake the project or not. For example , the cost of market study to estimate the demand for a product before deciding on the project is a sunk cost. Product development costs may be a sunk cost.

Sunk costs should not be considered as relevant cash flow for evaluating a capital project.

• Opportunity Costs

These are the costs which is not directly visible as an expense. Opportunity cost is the cost of lost benefit for undertaking a project.

For example, the company wants to build a plant on the land owned by the company. The land has a market value. Instead of selling the land and realising the market value, if the company builds a plant, the market value lost is the opportunity cost of the project. This cost should be consideredin the cash flow for evaluation of the project

• Capital expenditures

Capital expense are the cost of plant and equipment . The purchase costs, transportation costs of the equipment, cost of installation and testing till start of production should be considered as cash flow due to capital expenditures

• Working capital,

Working capitals are cash flows required for inventory and accounts receivable (less accounts payable)

The working capitals are normally released at the end of the project as positive cash flow in the terminal year

• Synergy gains

Synergy gains are increase in sales of other products due to introduction of a new product. For example, if a gas station adds a convenience stores, the sale of gas will increase . The increasedcash flow due to increased sale of gas should be considered in evaluating the project of the convenience stores.

• Erosion costs

This is opposite of synergy gain. For example, If an automobile company introduce a new model of car , there may be erosion cost due to reduction of sale of an exiting model. The decrease in cash flow due to erosion should be estimated and considered for evaluation of the project of new model

• Depreciation

The company expenses a part of the capital cost each year as depreciation.

Due to taxation, depreciation may give a positive cash flow as depreciation tax shield.

The capital assets also give apositive cash flow at terminal year as salvage value