Basic Principles to Observe
Forecasting the inflows and outflows of a venture requires the observance of certain principles in developing a set of cash projections. They serve as guidelines for determining the relevant or irrelevant items to be included or discounted in order to come up with the best cash flow estimation (CFE).
The most vital of these principles are (1) consistency (2) incremental and (3) separation.
(1) Consistency Principle
This principle takes into consideration two important aspects that can affect or be affected by the quality of the estimations: the investors’ expected income and inflation.
The project manager should bear in mind that some investors provide capital funds for the project usually in the form of bonds. They are contributing funds with the expectation that the bond instrument will yield profits in the form of interests. However, the rate of return should be consistently calculated as the net of all costs incurred to sustain the project. Thus, before presenting the viability of the project to investors, offers of potential rates of return should be net of the project’s estimated costs, including taxes.
In addition, the principle of consistency should likewise be applied when taking into account the occurrence of inflation. Consistency here means if an inflation rate will be applied to increase the investor’s expected income, the inflated costs incurred in generating the income should likewise be considered. Any interest paid as the cost of borrowed capital funds should also be calculated by using inflated interest rates.
If the CFE does not take into account the occurrence of inflation but instead makes use of real cash flows, then real interest rates should be used to increase the value of expected income and to increase the value of anticipated costs.