A typical investment will have three cash flow components:

1. Initial investment

2. Annual net cash flows

3. Terminal cash flows

1. Initial investment

The initial investment is the net cash outlay in the period in which an asset is purchased. An important element of the initial investment is the gross outlay or the original value of the asset, which includes its cost (including accessories and spare parts) and the costs of transportation and installation. The original value is included in the existing asset block to calculate annual depreciation. Similar types of assets are included in an asset block. The original value less depreciation is the book value of the assets. When an asset is purchased to increase income, it may also require a global investment in net working capital. Therefore, the initial investment will be equal to: the gross investment plus the increase in net working capital. Also, in case of replacement decisions, the existing asset will have to be sold if the new asset is acquired. The sale of the existing asset provides a cash inflow. Cash proceeds from the sale of existing assets must be subtracted to arrive at the initial investment. We will use the term Co to represent the initial investment. In practice, a large investment project can include multiple cost components and involve a huge initial net cash outlay.

2. Annual net cash flows

An investment is expected to generate annual cash flows after the initial cash outlay has been made. Cash flows should always be estimated after taxes. Some people advocate calculating cash flows before taxable income and discounting them at the pre-tax discount rate to find the net present value. Unfortunately, this will not work in practice, as there is no meaningful and easy way to adjust the discount rate before taxes. We will refer to after-tax cash flows as net cash flows and use the terms C1, C2, C3 …… respectively for period 1, 2, 3 ……… n. Net cash flow is simply the difference between cash receipts and cash payments, including taxes. Net cash flow will consist primarily of annual cash flows that occur from the operation of an investment, but will also be affected by changes in net working capital and capital expenditures over the life of the investment. . To illustrate, we first take the simple case where cash flows occur only from operations. Suppose that all income (sales) is received in cash and all expenses are paid in cash (obviously, cash expenses will exclude depreciation, as it is not a cash expense). Therefore, the definition of net flow will be:

Net cash flow = Income – Expenses – Taxes

Notice that in the equation, taxes are deducted to calculate after-tax flows. Tax is calculated on accounting income, which treats depreciation as a deductible expense.

3. Terminal cash flows

The last year or the last year of an investment may have additional flows.

• Rescue value

Salvage value is the most common example of terminal flows. The redemption value can be defined as the market price of an investment at the time of its sale. Cash proceeds net of tax from the sale of assets will be treated as cash inflows in the final (last) year. Under existing tax laws, no immediate tax liability (or tax savings) will arise on the sale of an asset because the value of the asset sold is adjusted on the assets base for depreciation. In the case of replacement decisions, in addition to the salvage value of the new investment at the end of its life, two other salvage values ​​should be considered:

1. The salvage value of the existing asset now (at the time of the replacement decision)

2. The salvage value of the asset existing at the end of its life, if it were not replaced.

If the existing asset is replaced, its salvage value will not increase the current cash inflow or decrease the initial cash outlay of the net assets. However, the company will have to give up its salvage value at the end of its useful life. This means less cash inflow in the last year of the new investment. The effects of the redemption values ​​of new and existing assets can be summarized as flows:

• Salvage value of the new asset. The cash inflow will increase in the final (last) period of the new investment.

• Salvage value of the existing asset now. It will reduce the initial cash outlay of the new asset.

• Salvage value of the existing asset at the end of its nominal life. It will reduce the cash flow of the new investment in the period in which the existing asset is sold.

At times it may be necessary to incur removal costs to replace an existing asset. The salvage value should be calculated after adjusting for these costs.


Leave a Reply

Your email address will not be published. Required fields are marked *