# 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:

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.

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

CF

CF

CF

CF

CF

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)

Operating CF

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.

**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.

**Answer:**

Initial Investment Outlay:Initial Investment Outlay

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

**Operating Cash Flow:**

CF_{t}= (revenues - costs)*(1 - tax rate)CF

_{1}= ($1,500 - $200)*(1 - 40%) = $780CF

_{2}= ($1,500 - $200)*(1 - 40%) = $780CF

_{3}= ($1,500 - $200)*(1 - 40%) = $780CF

_{4}= ($1,500 - $200)*(1 - 40%) = $780CF

_{5}= ($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. |

Return of net working capital +$300

Salvage value of the machine +$800

Tax reduction from loss (salvage < BV)

__+$80__

Net terminal cash flow $1,180Operating CF

_{5}__+$780__

Total year-five cash flow $1,960For 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.

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