To evaluate a project, must determine the relevant cash flow, which are the incremental after-tax cash flows associated with the project.
The cash flow stream of a conventional project – a project which involves cash outflows followed by cash inflows – comprises three basic components:
- Initial investment
- Operating cash inflows, and
- Terminal cash inflow
The initial investment is the after-tax cash outlay on capital expenditure and net working capital when the project is set up. The operating cash inflows are the after cash inflows resulting from the operations of the project during its economic life. The terminal cash inflow is the after-tax cash flow resulting from the liquidation of the project at the end of its economic life.
Time Horizon for Analysis
How is the time horizon for cash flow analysis usually established?
The time horizon for cash flow analysis is generally the minimum of the following:
- The physical life of the plant: This refers to the period during which the plant remains in a physically usable condition, i.e., the number of years the plant would perform the function for which it had been acquired. This depends on the wear and tear which the plant is subject to. Suppliers of the plant may provide information on the physical life under normal operation conditions. While the concept of physical life may be useful for determining the depreciation charge, it is not very useful for investment decision-making processes.
- Technological life of the plant: New technological developments tend to render existing plants obsolete. The technological life of a plant refers to the period of time for which the present plant would not be rendered obsolete by a new plant. It is very difficult to estimate the technological life because the pace of new developments is not governed by any law. While it is almost certain that a new development would occur when it would occur is anybody’s guess. Yet an estimate of the technological life has to be made.
- Product market life of the plant: A plant may be physically usable, its technology may not be obsolete, but the market for its products may disappear or shrink and hence its continuance may not be justified. The product market life of a plant refers to the period for which the product of the plant enjoys a reasonably satisfactory market.
- Investment planning horizon of the firm: The time period for which a firm wishes to look ahead for purposes of investment analysis may be referred to as its investment planning horizon. It naturally tends to vary with the complexity and size of the investment. For small investments (say, installation of a lathe) it may be five years, for medium size investments (say, expansion of plant capacity) it may be 10 years, and for large-size investments (say, setting up of a new division) it may be 15 years.