Complete Guide To Corporate Finance


Capital Investment Decisions - Project Cash Flows

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 Tricks
The 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
comments powered by Disqus
Related Articles
  1. How to Use the Gearing Ratio
    Investing Basics

    How to Use the Gearing Ratio

  2. What's a P&L Statement?
    Investing Basics

    What's a P&L Statement?

  3. How Does Goodwill Affect Financial Statements?
    Investing Basics

    How Does Goodwill Affect Financial Statements?

  4. Using Normal Distribution Formula To ...
    Investing Basics

    Using Normal Distribution Formula To ...

  5. The Government And Risk: A Love-Hate ...

    The Government And Risk: A Love-Hate ...

Trading Center