Prima facie, capital budgeting may seem like a very simple task. After all, it has just 3 steps. The first is to find the cash flows, the second is to find the appropriate discount rate that represents the time value and riskiness of those cash flows and the third step is to use both these inputs and discount the cash flows at the chosen rate.

However, in practice it is not that straightforward. There are many complications that arise during the process. Complications usually arise because neither of the variables that we are using in the projection is certain. We are therefore, at best choosing estimates. Deciding whether we have the right estimates is very important. A slight change could bring about a completely different valuation. In this article, we will first see how we can derive cash flows from accounting profits and then we shall have a closer look at some of the complications that may arise in the process of estimating cash flows.

Deriving Accounting Profits from Cash Flows

Capital budgeting is completely dependent upon cash flows. It is not concerned with the accounting profits of a project. Yet, most of the times analysts will have financial statements that talk about the accounting profit. So, they have to derive the cash flows from the accounting profit. This can be done by undoing the two adjustments that accountants make to come at the profit:

1. Accountants count income in the period it is earned. As opposed to this, cash flow needs to be accounted for in the period that it was received. Hence the numbers need to be adjusted.

2. Also, accountants segregate the cash outflows into expenses and asset creation. But when you consider cash, it’s just an outflow. So once again, this assumption also needs to be undone while computing the cash flows that need to be discounted.

Only Incremental Cash Flows

Secondly, it is important to consider each project as a separate investment and we must consider only the incremental cash flows that arise as a result of this investment decision. Consider for example that we decide to open up a restaurant in a property that we have already rented out for $10,000 a year. The cash inflow from this restaurant is expected to be $25,000 a year.

In this case, even though the nominal value of cash inflows is $25,000, in reality we are earning just $15,000 of additional money. Hence we will use $15,000 for our cash-flow calculations and not $25,000.The key is to consider the value of your firm with and without the investment. The idea is to look at both possible scenarios and decide which one we want to be in.

This part can be counter-intuitive for many people. But remember that we are only considered with the additional dollars that we will make as a result of this investment. Why should we consider what we are already earning from past projects into consideration to decide whether or not we should invest in the next one?

Incidental Effects

Also, it is important to consider the incidental effects of some projects. In theory, projects work in isolation. But we know for a fact that in reality that is not the case. The fate of many projects is usually interconnected.

Let’s say a car company is deciding whether or not it should introduce a new model of car. Now, let’s also say that this new model’s sales will decrease the sale of another model produced by the same company. They will cause the sale of the old model to drop by $12,000.

So, while calculating the cash inflows from the new model, we must subtract $12,000 from it. This is because without the project the company has the $12,000 but with the project, the company stands to lose $12,000. It may make additional money but $12,000 is an incidental cost that is being paid to undertake this project.

Hence, to gauge the real value of the project, incidental costs must also be taken into account.