Even Cash Flows

Definition

Even cash flows refer to a stream of equal, periodic cash inflows or outflows that occur over a specific timeframe. This concept is particularly relevant in the context of evaluating capital investment decisions, specifically the Payback and Accounting Rate of Return methods.

5 Must Know Facts For Your Next Test

1. Even cash flows simplify the analysis of capital investment decisions by providing a predictable and consistent pattern of cash inflows or outflows.
2. The Payback method, which calculates the time required to recover the initial investment, is particularly well-suited for evaluating projects with even cash flows.
3. The Accounting Rate of Return (ARR) method, which compares the average annual accounting profit to the initial investment, also benefits from the consistent nature of even cash flows.
4. Even cash flows allow for easier forecasting and planning, as the periodic amounts are known and can be reliably included in financial projections.
5. The presence of even cash flows can simplify the calculation of net present value (NPV) and internal rate of return (IRR), two other capital budgeting techniques.

Review Questions

• Explain how even cash flows can simplify the Payback method of capital investment evaluation.
  • With even cash flows, the Payback method becomes more straightforward. The initial investment can be divided by the consistent periodic cash inflows to determine the number of periods required to recover the initial outlay. This is in contrast to uneven cash flow patterns, where the Payback calculation requires a more complex, cumulative approach to determine the payback period.
• Describe the relationship between even cash flows and the Accounting Rate of Return (ARR) method.
  • The Accounting Rate of Return (ARR) method calculates the average annual accounting profit generated by an investment and compares it to the initial investment. Even cash flows facilitate this calculation, as the consistent periodic cash inflows or outflows can be easily averaged to determine the average annual profit. This simplifies the ARR computation and allows for more reliable comparisons across different capital investment projects.
• Analyze how the presence of even cash flows can impact the calculation of net present value (NPV) and internal rate of return (IRR) for a capital investment project.
  • Even cash flows enable more straightforward NPV and IRR calculations. With a consistent periodic cash flow pattern, the present value of future cash inflows or outflows can be easily determined using standard discounting formulas. Additionally, the internal rate of return, which is the discount rate that makes the NPV equal to zero, can be more readily identified when cash flows are even. This simplifies the capital budgeting analysis and allows for more accurate comparisons between investment alternatives.

Related terms

Cash Flows: The net amount of cash and cash-equivalents moving in and out of a business, especially as it affects liquidity.

Periodic Cash Flows: Cash inflows and outflows that occur at regular, consistent intervals, such as monthly, quarterly, or annually.

Capital Investment Decisions: The process of evaluating and selecting long-term investments, such as purchasing new equipment or expanding a business, to achieve organizational goals.