An investment proposal or an expenditure proposal must have estimated benefits and costs for doing engineering economic analysis. For simple proposals, the engineer making the proposal may be able to make these estimates. For complex proposals, involvement of marketing, production, maintenance and other operating departments and accounting department may be necessary. The estimation of benefits and costs are to be made keeping in mind the following principles.
Cash flow Estimation - Basic Principles
Cash flows of a project have to be estimated for a time horizon. The time horizon is the minimum of physical life of the plant, technological life of the plant, or the product market life.
Cash flow principle
In economic analysis, it is actual cash flow that is used. So the time at which actual cash is received or paid is to be estimated along with the amount of cash flow.
In estimating the cash flows of a project, incremental principle (that considers all incidental effects), separation of investment and financing principle, post-tax principle and consistency principles are employed.
In an existing company, the cash flows are to be estimated by evaluating the cash flows of the company with the project and without the project. The difference will be incremental cash flows related to the project.
Long-term funds principle
The cash flows reflect the benefits that accrue to long-term funds.
Interest exclusion principle - Separation of investment and financing principle
In a standard capital expenditure analysis, interest payment to be made on borrowings is not brought into the picture. Borrowing is considered a financing decision and its impact is included in the cost of capital estimation. Hence cash flow estimates do not have any interest payment component (interest paid for long term funds).
Tax impact on the cash flow is considered and after tax cash flows are estimated.
The inflation expectation built into estimation of revenues and costs and cost of capital have to be consistent or same.
Thus, in estimating the cash flows of a project, incremental principle (that considers all incidental effects), separation of investment and financing principle, post-tax principle and consistency principles are employed.