BASIC PRINCIPLES OF CASH FLOW ESTIMATION

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The following principles are consider in cash flows of the project: Separation principle. Incremental principle. Post-tax principle. Consistency principle.

SEPARATION PRINCIPLE
Different

sides of the project are: Investment side. Financing side. Cash flow associated with both sides.

EXAMPLE:
Financing side Time =0 Cash flow = +1000 Time = 1 Cash flow = -1150
Cost

Investment side Time = 0 Cash flow = -1000 Time = 1 Cash flow = +1200
Rate

of capital =15%

of return =

20%

 Cash

flow in investment side does not reflect in financing side. The 15% interest in financing side is reflected in investment side as cost of capital by which rate of return is evaluvated.

INCREMENTAL PRINCIPLE
The

cash flow of a project must be measured in incremental terms. Incremental cash flow is considered with the project and without the project. There are guidelines for this principle which are followed as the base.

GUIDELINES
Consider all incidentals effects. Product cannibalization. Ignore sunk cost. Include opportunity cost Allocation of overhead cost. Estimate net working capital.

POST-TAX PRINCIPLE
Cash flows should be measured on an after tax basis. Some firms may ignore tax payments and compensate this by discounting the pre-tax cash flows at a higher rate than capital of firm. As there is no reliable way of fixing the discount rate.

CONSISTENCY PRINCIPLE
Cash flows and the discount rates applied should be consistent with respect to investor group and inflation. Investor group: The cash flow of a project estimated from investors point of view. Investors view of cash flow is considered after paying the taxes and investment needs.