Project cash flows and risk - Identifying relevant cash flow...

Learning Outcomes

After studying this article, you will be able to distinguish relevant cash flows for project appraisal, identify and exclude non-relevant costs, and explain the importance of risk adjustments. You will practise classifying cash flows such as initial investment, operating inflows and outflows, and understand the treatment of opportunity costs and sunk costs for effective ACCA exam preparation.

ACCA Foundations in Financial Management (FFM) Syllabus

For ACCA Foundations in Financial Management (FFM), you are required to understand how to analyse investment projects by identifying the appropriate cash flows and recognising how risk and uncertainty influence decision-making. In particular, this article covers:

• The distinction between relevant and non-relevant cash flows in project appraisal
• The treatment of sunk costs, opportunity costs, and incremental cash flows
• How taxation and working capital affect project cash flows
• The influence of risk and uncertainty on project cash flows
• The identification of non-cash items and excluded costs in investment appraisal

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is NOT a relevant cash flow in project appraisal?
   1. Additional revenue generated by a new machine
   2. Cost to be incurred for staff retraining
   3. Depreciation expense on existing equipment
   4. Incremental working capital required by the project
2. What is an opportunity cost in the context of investment appraisal?
   1. The cost already incurred on a completed feasibility study
   2. The potential return forgone from using a resource in the next best alternative use
   3. Costs that are unavoidable
   4. The cash required to purchase new machinery

3. True or false? Sunk costs are always excluded from project cash flow calculations.

4. State two types of cash flows that should be included in a project appraisal.

Introduction

Careful identification of relevant cash flows is fundamental for reliable project evaluation and investment decisions. When a business considers a capital project, such as acquiring new equipment or launching a new service, it must forecast the future cash flows affected by that decision. Only cash flows that change as a direct result of accepting the project—known as incremental cash flows—should be considered. Incorrect inclusion of non-relevant costs, such as sunk costs or allocated overheads, can lead to poor investment decisions.

This article explains which costs and revenues to include or exclude when assessing potential projects. It covers the special treatment required for items like sunk costs, opportunity costs, working capital, and non-cash items, and considers how risk and uncertainty influence cash flow projections.

Key Term: Incremental cash flow
The change in total future cash flows resulting directly from accepting a project, i.e., additional cash inflows and outflows compared to not undertaking the project.

Key Term: Sunk cost
A cost that has already been incurred and cannot be recovered, regardless of future decisions. Sunk costs are irrelevant to project appraisal.

Key Term: Opportunity cost
The value of the next best alternative that is forgone when a resource is used for a specific project.

RELEVANT VERSUS NON-RELEVANT CASH FLOWS

For project appraisal, only incremental cash flows—those which occur because the project is undertaken—are relevant. The decision rules are as follows:

• Include only future cash inflows and outflows that arise as a direct consequence of the project
• Exclude all costs and revenues that remain unchanged whether or not the project proceeds

Included Cash Flows

• Initial outflows: The immediate cash spent on purchasing assets, installation, and any extra setup costs
• Incremental operating inflows: Sales revenue and savings generated by the project
• Incremental operating outflows: Operating costs, maintenance, and other expenses directly attributable to the project
• Opportunity costs: Gains given up by using company resources for this project instead of another use
• Tax effects: Additional taxes paid or saved due to the project's impact on profit
• Working capital changes: Additional cash tied up or released by inventory, receivables, or payables as a result of the project

Excluded Cash Flows

• Sunk costs: Past expenditures—for example, amounts spent on feasibility studies or pre-purchased land—are ignored as they cannot be recovered or changed
• Allocated fixed costs: Overheads that do not change as a result of the project should not be included
• Non-cash items: Accounting charges like depreciation or amortisation do not represent actual cash movements and are excluded (but may impact tax calculations)

Exam Warning Depreciation is excluded from project cash flows but may affect tax payments. Only consider its impact on taxable profit, not as a direct cash flow.

SPECIAL CASES IN PROJECT CASH FLOWS

Sunk Costs

Sunk costs are never relevant for project appraisal because they cannot be changed by future decisions.

Opportunity Costs

If an asset used in the project could have been sold or put to another use, its potential benefit forgone forms an opportunity cost and must be included in the appraisal as a notional outflow.

Working Capital

Cash flows tied up in working capital (inventory, receivables, payables) are included at the time the investment is made. Any working capital released at the end of the project (e.g., by selling inventory or collecting receivables) is treated as a cash inflow.

Taxation

When a project affects taxable income, include the tax payable or savings due to additional profits or allowable expenses. Ignore the tax rate if instructed to appraise on a pre-tax basis.

Residual Value

If the project will leave an asset with a resale or scrap value, include its expected proceeds as a final cash inflow.

COMMON MISTAKES: NON-CASH AND ALLOCATED COSTS

Allocated overheads—such as general management salaries apportioned arbitrarily—should only be included if they increase as a direct result of the project. Non-cash items, like depreciation, are ignored except for their impact on tax.

RISK AND UNCERTAINTY IN CASH FLOW APPRAISAL

Projected cash flows are subject to estimation risk. Adjust for risk by:

• Conducting sensitivity analysis (examining how cash flows change if assumptions change)
• Applying a risk-adjusted discount rate for higher-risk cash flows
• Considering scenario analysis to test best and worst cases

Worked Example 1.1

A company is evaluating a new machine costing $40,000. It expects additional cash inflows of $15,000 per year for four years. The marketing department spent $3,000 last year researching the market. The machine can be sold for $5,000 after four years. Should the $3,000 research cost be included as a cash outflow in project appraisal?

Answer:
No. The $3,000 spent on research is a sunk cost and must not be included. Only the $40,000 paid for the new machine is a relevant initial outflow. The $5,000 expected resale value is included as a final inflow.

Worked Example 1.2

JQ Ltd owns a vacant building, currently worth $100,000, which could be used for a new project. If not used, it could be immediately sold. Should the building's value be included in the project's initial investment?

Answer:
Yes. The opportunity cost is the $100,000 forgone if the building is used for the project. This amount must be treated as a notional outflow in the initial year of the appraisal.

Worked Example 1.3

An investment will require an additional $10,000 in stock and receivables, to be fully recovered at the end of year five. How should these amounts be reflected in the appraisal?

Answer:
The initial $10,000 working capital is an outflow at time zero. The full $10,000 is included as an inflow at project termination in year five.

Revision Tip

Review past exam questions on relevant and irrelevant costs. Strong questions often include hidden sunk costs or non-cash items—identify and exclude them to avoid losing marks.

Summary

Correctly identifying relevant project cash flows is essential for trustworthy investment decisions. Only future cash flows that change because of the project—incremental cash flows, opportunity costs, direct taxes, and working capital—should be included. Sunk costs and non-cash accounting entries must be ignored. Always consider the effect of risk and uncertainty on projected cash flows.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between relevant and non-relevant cash flows for project appraisal
• Identify and exclude sunk costs and non-cash items
• Explain the inclusion of opportunity costs and working capital in cash flow forecasts
• Describe the treatment of taxation and final asset disposal values
• Understand and apply adjustments for risk and uncertainty in project appraisals

Key Terms and Concepts

• Incremental cash flow
• Sunk cost
• Opportunity cost