
When beginning capitalbudgeting 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. TerminalYear 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 terminalyear cash flow for the expansion project.
Answer:
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%) = $780
CF_{2} = ($1,500  $200)*(1  40%) = $780
CF_{3} = ($1,500  $200)*(1  40%) = $780
CF_{4} = ($1,500  $200)*(1  40%) = $780
CF_{5} = ($1,500  $200)*(1  40%) = $780
Terminal Cash Flow:
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 CF_{5} +$780
Total yearfive 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
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. TerminalYear 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 terminalyear cash flow for the expansion project.
Answer:
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%) = $780
CF_{2} = ($1,500  $200)*(1  40%) = $780
CF_{3} = ($1,500  $200)*(1  40%) = $780
CF_{4} = ($1,500  $200)*(1  40%) = $780
CF_{5} = ($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. 
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 CF_{5} +$780
Total yearfive 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.
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