Cash-flow analysis

Cash-flow analysis is a planning device that looks at the cash flows into and out of a new project, new venture, equipment purchase, new product, etc. The manager analyzes the cash-flow predictions to determine the relative desirability of doing the new activity. One method of analyzing the cash flow is called the “payback period.” This simple technique evaluates the wisdom of carrying out a project by looking at the relative time it takes to pay back the initial INVESTMENT in the project. With this method, projects that pay back their original investment the quickest are considered superior to those that take longer. The major disadvantage of this method, which is often used by business and criticized by academics, is that it ignores cash flows after the payback period. Thus one project that brings in large cash flows after its payback period may be discarded in favor of a project that pays back the original investment rapidly. On the other hand, many business managers rightly want to minimize the time they are “at risk” with the investment, so they prefer projects that give them back their original investment rapidly. More sophisticated techniques involve discounted cashflow analysis. These techniques look at the time value of money and the effect of interest compounding, using relatively simple mathematical calculations to convert future cash flows to their “present value,” which is the present worth of future cash flows given a specified interest rate. Financial calculators do these calculations. The project that produces the highest present value is considered superior to those that produce a lower present value. Another way to use the same concept is to calculate each project’s internal rate of return—that is, the interest rate that the original investment earns in producing the project’s resultant cash flows. Often a company has a target internal rate of return that it demands from its projects and approves those projects that surpass the target or those with the highest internal rate of return. These cash DISCOUNTING techniques add a disarming degree of mathematical rigor to the cash-flow analysis, leading the unwary manager to ignore the underlying uncertainty of the cash flows themselves. To try to deal with this, some cash-flow analyses include analyzing the probabilities of the resulting cash flows prior to their being discounted. This produces an expected value of the cash flows.