THE ELEMENTS OF A CASH FLOW PROJECTION
A capital budgeting decision is characterized by costs and benefits (cash flows) that are spread out over several time periods. This leads to a requirement that the time value of money be considered in order to evaluate the alternatives correctly. Although in actual practice we must consider risk as well as time value, to situations in which the costs and benefits (in terms of cash) are known with certainty. There are sufficient difficulties in just taking the time value of money into consideration without also incorporating risk factors. To arrive at the set of projected incremental cash flows used in evaluating any investment, it is usually necessary to project the impact of the investment on the revenues and expenses of the company. Some investments will affect only the expense components (i.e., cost-saving investments), whereas others will affect revenues as well as costs. Projecting how various expense and revenue items will be affected. If the investment is undertaken is not an easy task, for incremental impacts are often difficult to assess. In some cases, such as the impact of a new product on the sales of an existing product that is considered a substitute, the problem is the uncertain extent of the erosion. In other cases, such as with overhead items (e.g., accounting services, plant security, a regional warehouse system), the problem arises because there is not a well-defined cash flow relationship between the incremental action contemplated and these costs. No exact solution exists to these knotty problems.
An investment in plant or equipment to produce a new product will probably also requires an investment in current assets less current liabilities (working capital). There may be an increase in raw material, work-in-process, and finished goods inventories. Also, if there are sales on credit rather than cash, accounts receivable will increase; that is, sales per the income statement will be collected with...
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