Developing Relevant Cash Flows

Chapter 3

Developing Relevant Cash Flows

To evaluate investment alternatives, the after-tax

cash outflows and inflows associated with each
project must be determined.

When a proposed purchase is intended to

replace an existing asset, the incremental cash
outflows and inflows that will result from the
investment must be measured.

Developing Relevant Cash Flows

The cash flows of any project having the conventional
pattern can include three basic components:
(1)an initial investment,
(2)operating cash inflows,
(3)terminal cash flow.
All projects, whether for expansion, replacement, renewal,
or some other purpose, have the first two components.
Some, however, lack the final component, terminal cash
flow.

1. INITIAL INVESTMENT
The term initial investment refers to the relevant cash
outflow to be considered in evaluating a prospective
capital expenditure.
The basic variables that must be considered in
determining the initial investment associated with a
capital expenditure are:
a) The cost of a new asset is the purchase price it
requires.
b) Transportation and installation costs are defined
as any added costs necessary to get an asset into
operation.

1. INITIAL INVESTMENT
c) Proceeds from the sale of old assets
If a new asset is intended to replace existing assets that are
being sold, the proceeds from the sale are considered a
cash inflow.
If costs are incurred in the process of removing the old
assets, the proceeds from the sale of the old assets are
reduced by these removal costs.
The proceeds from the sale of a replaced asset are often
referred to as the liquidation value of the asset.

1. INITIAL INVESTMENT

d) Taxes must be considered in calculating the

initial investment whenever a new asset
replaces an old asset that has been sold.

EXAMPLE
Let us assume that a firm purchased an asset two years
ago for $10000, having a normal recovery period of 5 years. The firm
is using the straight-line depreciation method. What will happen if
the firm now decides to sell the asset and replace it?

If the firm sells the old asset for $8000, which is more than its book
value (10000 2x2000 = $6000), the gain above book value is taxed.
The total taxable income of the firm will increase with $2000 ($8000
$6000), and therefore the firm will pay a higher corporate income tax
with 16% $2000 = $320.

If the firm sells the asset for $5000, an amount less than its book
value, it experiences a loss of $1000 equal to the difference between
the book value and the sale price ($5000 - $6000), and therefore the
firm will pay a lower corporate income tax with 16% $1000 = $160.

1. INITIAL INVESTMENT
e) Change in net working capital

Net working capital is the amount by which a firms current

assets exceed its current liabilities.
The difference between the change in current assets and
the change in current liabilities would be the change in net
working capital.
The change in net working capital is not taxable because
it merely involves a net build-up or reduction of current
accounts.

1. INITIAL INVESTMENT

Change in net working capital

EXAMPLE
Beta Enterprises is contemplating expanding its operations to meet the
growing demand for its products. In addition to Beta acquiring a variety
of new capital equipment, financial analysts expect that the following
changes in current accounts will occur:
current assets are expected to increase by $2200, and current liabilities
are expected to increase by $900, resulting in a $1300 increase in net
working capital.
Current account
Change in balance
Cash
+ $400
Accounts receivable
+ $1000
Inventory
+ $800
Current assets
+ $2200
Accounts payable
+ $900
Current liabilities
+ $900
Change in net working capital
+ $1300

Calculating the initial investment

Cost of new asset
+ Transportation and installation costs
- Proceeds from sale of old assets
+/- Taxes on sale of old assets
+/- Change in net working capital
Initial investment

Calculating the initial investment

Exemple
The Alpha Company is trying to determine the initial investment
required to replace an old machine with a new, much more sophisticated
model. The proposed machines purchase price is $38000 and an
additional $2000 will be required to install it. It will be depreciated using
the straight-line depreciation method, over its normal five-years recovery
period.
The old machine was purchased three years ago at a cost of $24000 and
was being depreciated using the straight-line depreciation method, over
its normal five-year recovery period. The firm has found a buyer willing to
pay $15000 for the old machine and to remove it at his own expense. The
firm expects that a $3500 increase in current assets and an $1800
increase in current liabilities will accompany the replacement. The firm is
profitable.

Calculating the initial investment

EXAMPLE
The only component of the initial investment required by the proposed
purchase that is difficult to obtain is taxes.
Depreciation of the old machine = $24000 / 5 years = $4800/year
The book value of the old machine = $24000 3x $4800 = $9600
Since the firm is planning to sell the old machine for $15000, more
than its book value, it will realize an increase with $5400 ($15000
$9600) of the total taxable income,
and therefore the firm will pay a higher corporate income tax with 16% x
$5400 = $864.

Calculating the initial investment

Exemple

The net cash outflow required at time zero:

Cost of new machine
$38000
+ Transportation and installation costs $2000
- Proceeds from sale of old machine $15000
+ Taxes on sale of old machine
$864
+ Change in net working capital
$1700 ($3500 - $1800)
Initial investment
$27564

2. OPERATING CASH INFLOWS

The benefits expected from a capital expenditure are measured
by its operating cash inflows, which are incremental after-tax cash
inflows.

Interpreting the term after-tax. Benefits expected to result

from proposed capital expenditures must be measured on
an after-tax basis, since the firm will not have the use of any
benefits until it has satisfied the governments tax claims.
Interpreting the term cash inflows. All benefits expected
from a proposed project must be measured on a cash flow
basis. Cash inflows represent money that can be spent, not
merely accounting profits, which are not necessarily
available for paying the firms bills.

2. OPERATING CASH INFLOWS

The operating cash inflows in each year can be calculated as follows,

using the projected earnings before depreciation, interest and taxes:

Projected earnings before depreciation, interest and taxes (EBDIT)

- Depreciation
= Projected earnings before interest and taxes (EBIT)
- Taxes
= Projected earnings before interest after taxes (EBIAT)
+ Depreciation
= Projected operating cash inflows (CFO)

2. OPERATING CASH INFLOWS

Interpreting the term incremental. The final step in

estimating the operating cash inflows to be used in
evaluating a proposed project is to calculate the
incremental or relevant cash inflows.

Incremental operating cash inflows are needed, since our

concern is only with how much more or less operating
cash will flow into the firm as a result of the proposed
project.

2. OPERATING CASH INFLOWS

EXAMPLE: The Alpha Companys estimates of
its revenues, expenses (excluding depreciation) and earnings
before depreciation and taxes are given in the table below:

Year Projected revenues

(1)
With proposed machine
1
$272000
2
272000
3
272000
4
272000
5
272000
With present machine
1
220000
2
230000
3
240000
4
240000
5
225000

Projected expenses
(excl. depreciation)
(2)

Projected earnings
before depreciation
and taxes [(1) - (2)]

$230000
230000
230000
230000
230000

$42000
42000
42000
42000
42000

199000
211000
223000
225000
212000

21000
19000
17000
15000
13000

2. OPERATING CASH INFLOWS

Depreciation expense for proposed and present machines
for the Alpha Company:
Proposed machine: $40000 / 5 years = $8000/year (for 5
years)
Present machine: $4800 / year (for year 1 and 2)
Since the present machine is at the end of the third year of
its cost recovery period at the time the analysis is
performed, it has only the final two years of cost recovery
yet applicable.

2. OPERATING CASH INFLOWS

Ex. Calculation of Operating Cash Inflows in year 1 for
Alpha Companys proposed and present machines:

Item

With
proposed
machine

Projected earnings before depreciation and $42000

taxes
- Depreciation
$8000
Projected earnings before taxes
$34000
- Taxes (16%)
$5440
Projected earnings after taxes
$28560
+ Depreciation
$8000
Projected operating cash inflows
$36560

With
present
machine
$21000
$4800
$16200
$2592
$13608
$4800
$18408

2. OPERATING CASH INFLOWS

Projected Operating Cash Inflows for the Alpha
Company:
Subtracting the operating cash inflows with the present machine from the
operating cash inflows with the proposed machine in each year results in
the incremental operating cash inflows for each year.
Year With
proposed
machine
(1)
1
$36560
2
$36560
3
$36560
4
$36560
5
$36560

With
present Relevant or Incremental Operating
machine
Cash Inflows for the Alpha
(2)
Company
(1)-(2)
$18408
$18152
$16728
$19832
$14280
$22280
$12600
$23960
$10920
$25640

3. TERMINAL CASH FLOW

The cash flow resulting from termination and liquidation of a project at

the end of its economic life is its terminal cash flow. Terminal cash
flow, which is most often positive, can be calculated using the basic
format presented below:

Proceeds from sale of proposed asset

- Proceeds from sale of present asset
+/- Taxes on sale of proposed asset
+/- Taxes on sale of present asset
+/- Change in net working capital
Terminal cash flow

3. TERMINAL CASH FLOW

Proceeds from sale of assets represent the amount net of any

removal costs expected upon termination of the project.

Taxes on sale of assets

The tax calculations apply whenever an asset is sold for a value different
from its book value.

If the net proceeds from the sale are expected to exceed book value, a
tax payment shown as an outflow for the proposed asset would occur.
A tax rebate shown as a cash inflow for the proposed asset would result
when the net proceeds from the sale are below book value.

3. TERMINAL CASH FLOW

Change in net working capital. The change in net

working capital reflects the reversion to its original
status of any net working capital investment reflected
as part of the initial investment.
Most often this will show up as a cash inflow
attributed to the reduction in net working capital; with
termination of the project, the need for the increased
net working capital investment is assumed to end.

3. TERMINAL CASH FLOW

EXAMPLE

Continuing with the Alpha Company presented earlier, assume that the
firm expects to be able to liquidate the proposed machine at the end of
its five-years life to net $5000 after paying removal costs. The present
machine can be liquidated at the end of the five years to net $0
because it will then be completely obsolete. The firm expects to recover
its $1700 net working capital investment upon termination of the project.
From the analysis of the operating cash inflows presented earlier, it can
be seen that both the proposed and present machines will be fully
depreciated and therefore have a book value of zero at the end of the
five years.
Since the sale price of $5000 for the proposed machine is greater than
its book value of $0, taxes will have to be paid on the $5000.

3. TERMINAL CASH FLOW

Proceeds from sale of proposed machine
(- Proceeds from sale of present machine)
- Taxes on sale of proposed machine
(+ Taxes on sale of present machine)
+ Change in net working capital
Terminal cash flow
$5900

$5000
0
16% x $5000 = $800
0
$1700

This represents the after-tax cash flow, exclusive of operating cash

inflows, occurring upon termination of the project at the end of year 5.