In finance and investment decision making, cash flow analysis is of paramount importance. These monetary flows represent the incoming and outgoing movements of money related to a project or an economic activity. In this section, we will explore the different aspects of cash flows and their impact on the profitability of investment projects.
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The Importance of Cash Flows
To assess the profitability of a project, the financial manager must consider the forecasts of the various departments of the company, such as research and development, supply, production, merchandising and marketing. These forecasts constitute the cash flows, ie the amounts of money expected in each period.
The ultimate goal of cash flow analysis is to determine whether the value of the business will increase by undertaking the project. For this, it is essential to focus on the marginal flows, that is to say the monetary flows that are specifically linked to the realization of the project. These marginal flows are those that would be absent if the project were not implemented.
However, it is crucial to consider the side effects that a new project can have on the rest of the company. For example, if the launch of a new product reduces the sales of an existing product, this should be taken into account in the analysis of the marginal flows of the new project. It is essential to ensure that variations in cash flows are attributable to the project itself and not to other external factors.
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Sunk costs and opportunity costs
When evaluating a project, it is necessary to distinguish sunk costs from opportunity costs. Sunk costs are expenses that would remain even if the project were not carried out. For example, if a business spent $100,000 on market research before deciding to launch a project, that cost should not be considered a project-related disbursement. They are irrecoverable because they have already been committed independently of the investment decision.
In contrast, opportunity costs are the costs associated with opportunities foregone by choosing a particular project. For example, if a company decides to build a new factory on land it already owns, it forgoes the ability to sell that land and collect $100,000. This amount represents the opportunity cost of using the land for the new project.
Cash flow estimate
The estimation of cash flows is the crucial step in the evaluation of an investment project. This complex task requires the collaboration of several departments within the company, including production, sales and finance. The objective is to identify all relevant cash flows for investors.
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Major investment projects often involve large capital outlays during the start-up phase. These capital disbursements are generally concentrated at the beginning of the project (t=0). It is essential to consider these disbursements separately when analyzing cash flows.
Distinction between accounting profit and cash flow
It is important to note that accounting profit differs from cash flow. Accounting profit is based on accounting principles and may include items not relevant to the valuation of an investment project. In contrast, cash flows represent the actual amounts of money that will be in and out due to the project.
Delays between accounting records and the actual movement of money can also create differences between accounting profit and cash flow. In addition, the tax savings resulting from the depreciation tax deduction must be considered as real cash flows for investors.
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The financial approach to assess cash flows
In finance, we distinguish cash flows from funding decisions. The evaluation of an investment project should focus on the elements specifically related to the project, and not on the general financing factors of the company. Therefore, finance charges should not be included in the cash flow analysis, as this would count interest twice.
Estimating cash flows therefore requires adjustments with respect to the accounting approach. It is crucial to consider residual cash flows for investors, taking into account when transactions are recorded and the fact that taxes may differ from actual payments to governments.
Conclusion
Cash flows are an essential part of financial analysis and investment decision making. They make it possible to assess the profitability of a project by focusing on the marginal flows specifically linked to it. Sunk costs and opportunity costs play a crucial role in this assessment.
It is important to distinguish between accounting profit and actual cash flows. Cash flow estimates require adjustments from the accounting approach to reflect actual cash flows related to the project.
In conclusion, a thorough cash flow analysis enables financial managers to make informed investment decisions and maximize business value.
