When beginning capital-budgeting analysis, it is important to determine a project's cash flows. These cash flows can be segmented as follows:

1. Initial Investment Outlay
These are the costs that are needed to start the project, such as new equipment, installation, etc.

2. Operating Cash Flow over a Project's Life
This is the additional cash flow a new project generates.

3. Terminal-Year Cash Flow
This is the final cash flow, both the inflows and outflows, at the end of the project's life; for example, potential salvage value at the end of a machine's life.
Example: Expansion Project
Newco wants to add to its production capacity and is looking closely at investing in Machine B. Machine B has a cost of \$2,000, with shipping and installation expenses of \$500 and a \$300 cost in net working capital. Newco expects the machine to last for five years, at which point Machine B will have a book value (BV) of \$1,000 (\$2,000 minus five years of \$200 annual depreciation) and a potential market value of \$800.

With respect to cash flows, Newco expects the new machine to generate an additional \$1,500 in revenues and costs of \$200. We will assume Newco has a tax rate of 40%. The maximum payback period that the company has established is five years.

Let's calculate the project's initial investment outlay, operating cash flow over the project's life and the terminal-year cash flow for the expansion project.

Initial Investment Outlay
:
Machine cost + shipping and installation expenses + change in net working capital = \$2,000 + \$500 + \$300 = \$2,800

Operating Cash Flow:
CFt = (revenues - costs)*(1 - tax rate)
CF1 = (\$1,500 - \$200)*(1 - 40%) = \$780
CF2 = (\$1,500 - \$200)*(1 - 40%) = \$780
CF3 = (\$1,500 - \$200)*(1 - 40%) = \$780
CF4 = (\$1,500 - \$200)*(1 - 40%) = \$780
CF5 = (\$1,500 - \$200)*(1 - 40%) = \$780

Terminal Cash Flow:

 Tips and TricksThe key metrics for determining the terminal cash flow are salvage value of the asset, net working capital and tax benefit/loss from the asset.

The terminal cash flow can be calculated as illustrated:

Return of net working capital +\$300
Salvage value of the machine +\$800
Tax reduction from loss (salvage < BV) +\$80
Net terminal cash flow \$1,180
Operating CF5+\$780
Total year-five cash flow \$1,960

For determining the tax benefit or loss, a benefit is received if the book value of the asset is more than the salvage value, and a tax loss is recorded if the book value of the asset is less than the salvage value.

Incremental Cash Flows

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