Cash Flow Analysis and Capital Rationing

Cash flow Analysis and Capital Rationing
Name
University

CASHFLOW ANALYSIS AND CAPITAL RATIONING
Caledonia Products Company should focus on the cash flow rather accounting profit in taking its capital budgeting decisions. The accounting profit is calculated on accrual basis which doesn’t present the actual cash position of the company. Cash is like lifeblood to the company and no company can pay bills or survive without sufficient cash resources. Cash flow for current year and discounted cash flows for future (taking into account present value of money) can show a better picture of the economic earnings from a capital budgeting decision and hence can be more relevant than accounting profit (Megginson & Smart, 2005).
While making capital budgeting decisions the company should focus on relevant cash flows which are derived from incremental cash flows. Incremental cash flows are the marginal benefits that result from a proposed investment. It is calculated by ignoring tax considerations, fixed costs and non-cash expenses. On the other hand, total profits take into account the non-cash expenses, taxes, fixed costs and other costs which are not relevant to the decision making of capital budgeting. The free cash flows are the residual cash flow after meeting all the expenses and liabilities of the company, left to be distributed among all kind of investors. These do not even focus on the marginal benefits associated with a proposed investment (Megginson & Smart, 2005).
Depreciation is a non- cash expense and has no direct effect on the cash flow of a company. However, depreciation affects the company’s free cash flow indirectly. Since depreciation is a P&L item, it is subtracted from accounting profit on which the taxes are paid and the taxes paid reduce the free cash flow. In this way while calculating the free cash flows the, depreciation used in the calculation of the tax expense is used because that is the only way how depreciation affects the free cash flow of the company (Megginson & Smart, 2005).
While calculating the cash flows associated with a certain project the decision is based on the incremental cash flow of the project. Sunk cost is a cost that is irrecoverable and has already been paid in the past and has no incremental effect on the cash flow. An important point here to make is that sunk cost does affect the cash flow but it has no effect on the incremental cash flows associated with a project. Hence they are irrelevant to decision making for accepting or rejecting a project (Megginson & Smart, 2005).
The initial outlay of the project would include the necessary cash outflow that will be required for a project. These would usually include the cost to purchase an asset and put in operating order, installing the asset, initial investments etc. (Keown, Martin & Petty, 2008). The initial outlay for the introduction of a new product for Caledonia Products Company would be $ 8,100,000, which can be c...