Phase 2 – Step 5: Determine the cash flows the investment will return.

Under accrual accounting, revenues and expenses are reported based on accounting principles that are designed to be consistent from company to company and are also designed to report historical results. Revenues are reported when they are earned, and expenses are matched to the periods of the revenue. For capital investment analysis, however, we want a simpler but yet accurate measure of the results of our investment so we can compare options. Cash flows give us a solid basis for that analysis.

For instance, let’s say we are now four years in the future. Becker had to invest $43,800 in her business to buy the van. She then worked 20 hours per week for four years, taking two weeks off each year, so she worked a total of 4,000 hours, making $26,000 in delivery fees each year for a total gross cash inflow of $104,000. If she had chosen a minimum wage job instead, at $12 per hour, she would have earned only $48,000 but she would still have the $43,800 she invested in the van, for a total of $91,800. In addition, although she earned $104,000 in fees, she had to pay $49,000 in expenses (fuel, maintenance, etc.). In addition, if she had invested the $43,800 in a mutual fund that returned 6% per year, that $43,800 would have grown to $55,296.49.

Let’s take a look at what Becker’s Form 1040 “Schedule C – Self-employment Income” might look like for the four years she owned this particular van:

One noticeable difference is that accounting income, and the tax code, allocate the cost of the asset over its useful life. In this case, Becker has divided the initial cost less the residual value by 4 years (($43,800 – $10,000) / 4 = $8,450) and is reporting that as an expense each year. This is just a simple example. There are many more differences between accounting income and cash flows. In any case, in capital budgeting, we use cash flows in our decision-making process for both simplicity and accuracy.

Here again, are the cash flows Becker has estimated. Notice that cash flows include the initial cost of the van in the year of purchase, not prorated over the life of the van (depreciation):

Operating costs are determined on a cash basis. For Becker’s capital investment project, she has projected the following:

Finally, we determine any residual cash flows, such as the estimated sales price of the van when Becker is done with it, and we can tally up all of the cash in and out during the time horizon of the decision. Let’s say she estimates the residual value of the van to be $10,000 at the end of 4 years.

Year 1 cash inflows are revenues of $26,000. Cash outflows are the operating expenses of $9,750 plus the total initial investment of $43,800:

The final year’s cash inflows include the $10,000 sales price of the van.

Here is a quick theoretical review of the use of cash flows in capital budgeting:

You can view the transcript for “Capital Budgeting – Relevant Cash Flows” here (opens in new window).

There are other issues to take into account here, such as taxes, and even qualitative issues for Becker such as the pride that comes from being her own boss. However, on the face of it, just looking at cash flows, without even taking into account the time value of money, she would have been far better off to put the $43,800 into a savings account and get a part-time job.

Once we have gathered all of the quantitative and qualitative data, we are ready to assess the project. As you can see, total cash flows for Becker’s four-year project are $21,200, but is that acceptable? Does it make sense?

To answer these questions, we have to assess the risk and rewards and compare this to our alternatives, which we will do in the next section.

First, check your understanding of the reasoning behind using cash flows to analyze investment options rather than financial accounting rules.