BASIC PRINCIPLES OF CASH FLOW ESTIMATION The following principles are consider in

cash flows of the project:o Separation principle.o Incremental principle.o Post-tax principle.o Consistency principle.

SEPARATION PRINCIPLEDifferent 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 of capital =15%

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

Rate 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 PRINCIPLEThe 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.

GUIDELINESConsider all incidentals effects.Product cannibalization.Ignore sunk cost.Include opportunity costAllocation of overhead cost.Estimate net working capital.

POST-TAX PRINCIPLECash 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 PRINCIPLECash 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.