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.
The cash flows of any project having the conventional pattern can include three basic
components: (1) an initial investment, (2) operating cash inflows, and (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.
3.1. INITIAL INVESTMENT
The term initial investment refers to the relevant cash outflow to be considered in
evaluating a prospective capital expenditure. It is calculated by netting out all outflows and
inflows occurring at time zero (the time the expenditure is made) to get the initial outlay at
time zero.
The basic variables that must be considered in determining the initial investment
associated with a capital expenditure are:
The cost of a new asset. The cost of a new asset is the purchase price it requires.
Transportation and installation costs. Transportation and installation costs are
defined as any added costs necessary to get an asset into operation.
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. These proceeds help to reduce the cost of the
new asset, thereby reducing the firms initial investment.
Taxes. 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.
Change in net working capital. Net working capital is the amount by which a firms
current assets exceed its current liabilities. If a firm acquires new machinery to expand its
level of operations, accompanying such expansion will be increased levels of cash, accounts
receivable, inventory, and accounts payable. As long as the expanded operations continue, the
increased investment in current assets (cash, accounts receivable, and inventory) and

increased current liability (accounts payable, accruals) would be expected to continue. The
difference between the change in current assets and the change in current liabilities would be
the change in net working capital. Generally, current assets increase by more than current
liabilities, resulting in an increased investment in net working capital, which would be treated
as an initial outflow associated with the project. If the change in net working capital were
negative, it would be shown as an initial inflow associated with the project. The change in net
working capital is not taxable because it merely involves a net build-up or reduction of
current accounts.
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
Cash
Accounts receivable
Inventory
Current assets
Accounts payable
Current liabilities
Change in net working capital

Change in balance
+ $400
+ $1000
+ $800
+ $2200
+ $900
+ $900
+ $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
EXAMPLE
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-year
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.
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% $5400 = $864.
The net cash outflow required at time zero:
Cost of new machine
+ Transportation and installation costs
- Proceeds from sale of old machine
+ Taxes on sale of old machine
+ Change in net working capital
Initial investment

Depreciable outlay
$38000
$2000
$15000
$864
$1700 ($3500 - $1800)
$27564

3.2. 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. These claims depend on the
firms taxable income, so the deduction of taxes prior to making comparisons between
proposals is necessary for consistency. Consistency is required in evaluating capital
expenditure alternatives, since the intention is to compare like benefits.
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.
The basic calculation requires adding any non-cash charges deducted as expenses on the
firms income statement back to net profits after taxes. The most common non-cash charge
found on Income Statements is depreciation. It is the only non-cash charge that will be
considered in this section.
The operating cash inflows in each year can be calculated as follows, using the
projected earnings before depreciation and taxes:
Projected earnings before depreciation and taxes
- Depreciation
Projected earnings before taxes
- Taxes
Projected earnings after taxes
+ Depreciation
Projected 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.
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

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.
Ex. Calculation of Operating Cash Inflows in year 1 for Alpha Companys proposed
and present machines:
Item
Projected earnings before depreciation and taxes
- Depreciation
Projected earnings before taxes
- Taxes (16%)
Projected earnings after taxes
+ Depreciation
Projected operating cash inflows

With
proposed
machine
$42000
$8000
$34000
$5440
$28560
$8000
$36560

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

Ex. Calculation of Operating Cash Inflows in year 3 for Alpha Companys proposed and
present machines:
Item
With
With present
proposed
machine
machine
Projected earnings before depreciation and taxes
$42000
$17000
- Depreciation
$8000
Projected earnings before taxes
$34000
$17000
- Taxes (16%)
$5440
$2720
Projected earnings after taxes
$28560
$14280
+ Depreciation
$8000
Projected operating cash inflows
$36560
$14280

Projected Operating Cash Inflows for the Alpha Company:

Year
With proposed With
present
machine
machine
(1)
(2)
1
$36560
$18408
2
$36560
$16728
3
$36560
$14280
4
$36560
$12600
5
$36560
$10920
The values given for each year in column 2 of the previous table represent the amount
of operating cash inflows the Alpha Company will receive without the proposed expenditure.
If the proposed machine replaces the present machine, the firms operating cash inflows for
each year will be those shown in column 1.
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. These are the relevant inflows to be considered in evaluating the
benefits of making a capital expenditure for the proposed machine.
Year
1
2
3
4
5

Relevant or Incremental Operating

Cash Inflows for the Alpha
Company
$18152
$19832
$22280
$23960
$25640

3.3. 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
Proceeds from sale of assets. The proceeds from sale of assets represent the amount
net of any removal costs expected upon termination of the project. It is not unusual for the
values of assets to be zero at termination of the project.
Taxes on sale of assets. Like the tax calculation on sale of old assets demonstrated
earlier as part of finding the initial investment, taxes must be considered on the terminal sale.
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.
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. As noted earlier, the change in net working capital is for
convenience assumed to occur spontaneously in this case, upon termination of the project.
In reality, it may take a number of months for net working capital to be worked down to zero.
Since the net working capital investment is no way consumed, the amount recovered at
termination will equal the amount shown in the calculation of the initial investment. Tax
considerations are not involved because the change in net working capital results from a
reduction or build-up of current accounts.
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-year 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.
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

$5000
0
16% $5000 = $800
0
$1700
$5900

This represents the after-tax cash flow, exclusive of operating cash inflows, occurring
upon termination of the project at the end of year 5.