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Common errors in appraisal cash flow

Depreciation costs are included

I have even seen accountants (who should know better) make this mistake. Depreciation does not go in because it is not a cash flow; the cash flow relating to fixed assets - property, plant and equipment - is the amount spent when the assets are purchased, usually at the earliest stages of a project. If you included depreciation, which is a cost arising out of the application of the matching or accruals concept, you would be double-counting.

Interest and loan repayment are included

The cash flow forecasts for operational management, once the investment has been made, would include those for borrowing and repaying, as these must be made, and by the due dates.

The appraisal cash flow is prepared to calculate whether the outflows on capital and for operational costs, as adjusted for the time value of money at the required rate, are compensated for by inflows discounted at the required rate.

If a project can give a positive NPV at a required rate, it can then return that rate to investors. Therefore, to include either the capital element of the loan repayments or the interest element or both would mean double-counting.

Sunk costs

When an individual or an entity invests, they are naturally, and rightly, looking at the investment from their own, selfish, viewpoint. Thus, if an investment is now proposed that will build on a previous investment, the amount of that investment cost is not relevant - it is a sunk cost. For example, a resort hotel may have been planned and work commenced 10 years ago, but an economic downturn meant that the project was abandoned after only the access roads had been built. Looking at the viability of the project now, 10 years later, the roads are effectively free. Economists often take a 'bigger picture' view of the world and can claim that the access road costs should be recovered. I often say that economists are resurrectionists!

 
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