Video Transcript
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.
Operating Cash Flows
Operating cash flows are the cash flows produced during the project. They will only be realized if the project or investment is approved. If Mr. Tater assumes that his new equipment will generate $50,000 in additional sales over the life of the machine, which is 8 years, then his operating cash flow for the investment will be: $50,000 x 8 years, or $400,000.
Terminal Cash Flows
Terminal cash flows are the cash flows incurred at the end of the project. For example, at the end of the new equipment's useful life, Mr. Tater could sell the equipment for $10,000. Since this is money coming into the Crunchy Spud Potato Chip Company, it represents a cash inflow.
Changes in Net Working Capital
As noted, the formula for working capital is:
Working capital = Current assets - Current liabilities
When an investment is made, it's often necessary to purchase more inventory, which means that the amount you owe your suppliers (accounts payable) will also increase. Let's assume that as a result of purchasing the new machine, Mr. Tater has to invest an additional $20,000 in sweet potatoes, use $10,000 in cash to pay new employees who will work the machine, and ends up owing his suppliers an additional $15,000 as a result of the new product. Mr. Tater's net working capital would be: $20,000 + $10,000 - $15,000, or $15,000.
Stand-Alone Principle
Companies have many projects going on at any given time. To assess whether a specific project should be undertaken, it is necessary to focus on only the cash flows that will be generated from that project. This is known as the stand-alone principle. In other words, cash flows from other activities of the company are ignored when evaluating whether to approve the investment. The Crunchy Spud Potato Chip Company generates cash flows from its current product lines, but these cash flows would be ignored when evaluating whether Mr. Tater should proceed with the investment of the new machine.
Lesson Summary
When a business is contemplating a new project, the stand-alone principle states that only cash flows for that project should be considered. Specifically, relevant cash flows, or those cash flows that will only occur if the company proceeds with the project or investment, must be considered. Relevant cash flows will occur in the future and are incremental.
Cash flows from activities that occurred in the past are sunk costs and are not relevant to the decision. Initial cash flows are those from the initial investment, operating cash flows come in over the life of the project, and terminal cash flows are those that arise from the disposition of the investment.
