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When should Capital Cash Flow (CCF) approach be used in evaluating a project?
The choice of using Capital Cash Flow (CCF) in evaluating an investment project is related more to convenience than theoretical grounds. CCF is not the only approach for evaluating an investment project. It is used to evaluate a project when some certain conditions are present. In this article, we will discuss the conditions that should be met in order to choose CCF as an evaluation tool for an investment project.
The evaluation of a project rests more on whether debt is fixed, or the debt-to-equity ratio is fixed in an investment. The fact is that, calculations of a project can be done in both ways - depending on whether the debt or debt ration is fixed.
If the debt value is fixed, it will remain constant over the entire period of a project.
When the debt ratio is constant, the debt and equity values may change on a yearly basis over the period of the investment project.
Use of Capital Cash Flow Approach
When the value of debt of an investment project is fixed or when the repayment schedule is given, it is easy to use CCF approach or the APV approach.
The CCF results are same when the debt value does not change with APV results which is why it is also known as compressed APV approach.
Although both CCF and APV approaches rest on similar grounds, the CCF approach provides a better understanding of the capital structure of a project than the APV approach.
The CCF approach can easily handle the use of financing effects that may occur during the lifetime of a project. In fact, when the financing effects influence the cash flow of the project, the CCF approach is the best option to determine the value of a project. Therefore, when the value of debt is fixed and alternating factors are well-known, the CCF approach is best to determine the value of a project.
The CCF approach can also handle the influence of interest tax shields easily to show the effect of tax savings and thereby the benefit of interest tax shields on the overall value of a project. The CCF approach however is based on the assumption that debt is fixed which implies only the equity value of the project may change in the lifetime of a project.
Both CCF and APV approaches need complex calculations of the project's value in each period to imply the value of the implied debt flows in a project. Therefore, using the CCF approach is a matter of using constant debt over the entire period of a project. In fact, both CCF and APV approaches are better for evaluating a project when the debt (rather than the debt ratio) remains constant.
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