Cost and Benefit Principle

Once an investment project is proposed, its cost and benefits must be estimated. This is usually done with the help of inputs provided by marketing, production, accounting and other departments. The role of the financial manager is to keep the exercise focused on relevant variables, co-ordinate efforts of various participants in this process and ensure that podcasts are reasonably balance and internally consistent. Usually the outcome of this process is the set of projections prepaid according to conventional Accounting principles. In order to derive the relevant stream of cost and benefits from these projections, the financial manager must bear in mind the following principles:

Cash flow principle

Long term funds principles

Interest exclusion principle

Posts tax principle

Cash flow principle 

Cost and benefits must be measured in terms of cash flows - costs are cash outflows and benefits are cash inflows. Cash outflows, not expenses as determined by accounting conventions, Aarti relevant measure of course because they represent the flow of purchasing power. By the same token, cash inflows, not revenues as determined by accounting conventions, reflect benefits properly.

As there is usually a time difference between the recognition of revenues and expenses in accounting and the incidence of cash flows, a rigorous analysis requires that each item of revenue and expense be examined to find out the cash flows associated with it. For example, the pattern of collection associated with trade sales and the pattern of payments associated with credit purchases have to be analysed. This kind of detailed analysis, however, becomes to unwieldy and cumbersome for real life projects. Moreover, when we are concerned defining a cash flows on a yearly basis, as is usually done in project appraisal, a significant portion of such detailed analysis is deducted because it helps in getting only a more refined picture of intra-year cash flows. So, from a practical point of view, its suffices If depreciation and other non cash charges, which are deducted in computing profits from the accounting point of view, are added back because it do not result in cash outflow.

Incremental Principle 

Cash flows must be measured in incremental terms. This means that the changes in the cash flows of the firm which can be attributed to the proposed project alone are relevant. In estimating the incremental cash flows of a project, the following guidelines must be borne in mind:

1. Consider all incidental effects: in addition to the direct cash flows of the project, all its incidental affects on the rest of the firm must be considered. The project may enhance the profitability of some of the existing activities of the form because it has a complimentary relationship with them; or, it may detract from the profitability of some of the existing activities of the firm because it had a competitive relationship with them- all these effects must be taken into accounts.

2. Ignore sunk cost: sunk costs represents past outlets which cannot be recovered. They are not relevant for new investment decisions. For example, if a company has spent, say, ₹5 million on some preliminary work before deciding whether it should undertake an investment, the amount of ₹5 million is totally irrelevant, as it represents a sunk cost, as far as the investment decision is concerned. Remember the phrase "bygones are bygones".

3. Include opportunity cost: if a project requires the use of some resources already available with the firm, the opportunity cost of these resources should be charged to the project. The opportunity cost of a resource if the valley of net cash flows that can be derived from it if it were put to its best alternative use. Suppose a project requires a vacant piece  of firm. The cost of this land represents a sunk cost and is irrelevant for the new project decision. But the project should be charged with the opportunity cost of this  land which represents the benefit that can be derived from it by putting it to its best alternative use, which in this case is simply be leasing the land to another firm.

4. Question the allocation of overhead costs: costs which are are only indirectly related to a product or service are referred to as overhead costs. They includes item like general and administrative expenses, managerial salaries, legal expenses, rent and so on. Accountants normally allocate these overhead cost to various products on some basis like labor-hours or machine hours which appears acceptable. Hence when a new project is proposed, a proportion of the overhead costs of the firm is usually allocated to it. The overhead allocated to it, however, has hardly any relationship with the incremental overhead cost, if any, associated with it. For the purpose of investment appraisal what matters is the incremental overhead cause along with other incremental cost attribute to the project and not the allocated overhead cost.

Long term Funds Principle: there are several points of view from which a project can be viewed. For example:-

1. Long term funds comprises of equality and long-term debt.

2. Current liabilities comprises of bank advance and spontaneous current liabilities such as trade credits, provisions, etc..

3. Total funds comprises of long term funds and current liabilities.

4. Fixed assets are fully supported by long term funds. 

5. Current assets are partly supported by long term funds and partly supported by current liabilities. The portion of current assets that is supported by current liabilities. The portion of current assets that is supported by long term funds is called the net working capital.

Now, a project may be viewed from three distinct point of view:

1. Equity point of view

2. Long term funds point of view

3. Total funds of point of view

In capital budgeting, the long term funds point of view is commonly adopted, though one can adopt any of the three points of view. What is important is that the measures of cash flows and cost of capital must be consistent with the point of view adopted.

For the present discussion, the long term funds point of view is adopted. Hence, the question that need to be answered are: what is the sacrifice made by the suppliers of long term funds ? What benefits accrue to the suppliers of long term funds ?

The sacrifice made by the suppliers of long term funds is equal to the outlets on fixed assets and net working capital. The net working capital, which represents the difference between current assets and current liabilities, is supported by the long term funds. The benefits accruing to the suppliers of long-term points consists of operation cash flows after taxes and salvage value of fixed assets and net working capital.

Interest exclusion principle: When cash flows relating to long term funds are being measured, interest on long term debt should not be considered. Why ? The average cost of capital used for evaluating the cash flows takes into account the cost of long-term debt. Put differently, interest on long term debt is properly reflected through the average cost of capital. Hence, if interest earned on term deposit deducted in the process of cash flow analysis, the cost of long-term debt will be counted twice- an error which should be carefully guard.