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5.3 Do cash flows really occur at year ends?

Discounting cash flows rather than profits does not really mean that depreciation is

ignored. It is in effect taken into account by treating the initial investment as an

outflow of cash and the disposal proceeds as an inflow, thus in effect charging the

difference between these amounts to the project.

5.3 Do cash flows really occur at year ends?

In the examples that we have considered so far, all of the cash flows have occurred

exact numbers of years after the start of the project. This obviously is not very repres-

entative of real life.

Most investments undertaken by businesses are in land, buildings, plant, machin-

ery, trading inventories and so forth. The returns from these are in the form of sales

revenues against which have to be set costs of labour, materials and overheads.

Clearly, these cash flows are not likely to occur at year ends. They tend to be spread

throughout the year, perhaps fairly evenly or perhaps more concentrated at some

parts of the year than at others, reflecting the seasonal aspect of certain trades.

Strictly, the precise timing of the cash flows should be identified and they should

be discounted accordingly. The discount factor 1/(1 +r)nwould be the same; however,

the nwould not necessarily be a whole number.

Although it would be perfectly feasible to recognise the precise timing of cash

flows, it seems not to be usual to do so. The simplifying assumption that cash flows

occurring within a year occur at the year end is thought to be popular in practice.

Making this assumption tends to introduce an element of bias in that it usually treats

cash flows as occurring a few months later than they actually do. This tends to have

A project that involves an initial outlay of £200,000 on a machine is expected to gener-

ate annual profits of £60,000 (after deducting depreciation) each year for four years.

Depreciation is calculated on an even (straight line) basis, assuming that the disposal pro-

ceeds of the original investment will be £40,000 receivable at the end of year 4. This means

that the annual depreciation expense will be £40,000 [(£200,000−£40,000)/4]. The initial cost

is an outflow in year 0 (immediately) and the disposal proceeds are an additional inflow in

year 4. The working capital requirement is estimated to be a constant £30,000. The estim-

ated cash flows will be

Year £

0 (230,000) (i.e. machine £200,000 +working capital £30,000)

1 100,000 (i.e. pre-depreciation profit £60,000 +depreciation £40,000)

2 100,000

3 100,000

4 170,000 (i.e. £100,000 +disposal proceeds £40,000 +working capital

released £30,000)

and it is these figures that should be discounted, using an appropriate rate, to arrive at

the NPV.

Example 5.2