Part two or continuity from the previous posting regarding the capital investment decisions. We shall look into the projected cashflow. The cashflow plays an important tole in determining the viability of the undertaken project. Basic rule is by applying the NPV method that we’ve learned previously. That’s basic. Here I just want to share the deatils about it. Again, I’ve browsed the net from the same page, well I think you also can do that…
When beginning capital-budgeting 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. 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.
Initial Investment Outlay:
Machine cost + shipping and installation expenses + change in net working capital = $2,000 + $500 + $300 = $2,800
Operating Cash Flow:
CFt = (revenues – costs)*(1 – tax rate)
CF1 = ($1,500 – $200)*(1 – 40%) = $780
CF2 = ($1,500 – $200)*(1 – 40%) = $780
CF3 = ($1,500 – $200)*(1 – 40%) = $780
CF4 = ($1,500 – $200)*(1 – 40%) = $780
CF5 = ($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.
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
Total year-five 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 flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company’s cash flow will increase with the acceptance of the project.
There are several components that must be identified when looking at incremental cash flows: the initial outlay, cash flows from taking on the project, terminal cost (or value) and the scale and timing of the project. A positive incremental cash flow is a good indication that an organization should spend some time and money investing in the project.
Incremental Cash Flow and Capital Budgeting
When determining incremental cash flows from a new project, several problems arise: sunk costs, opportunity costs, externalities and cannibalization.
1. Sunk Costs
These are the initial outlays required to analyze a project that cannot be recovered even if a project is accepted. As such, these costs will not affect the future cash flows of the project and should not be considered when making capital-budgeting decisions.
Suppose Newco is considering whether to make an addition to its current plant to increase production. To determine if the new addition is worthwhile, Newco hired a consulting firm for $50,000 to analyze the addition and the effect it will have on production. The $50,000 is considered a sunk cost. If the project is rejected, the $50,000 will still be paid, and if the project is accepted, the $50,000 will not affect the future cash flows of the addition.
2. Opportunity Cost
This is the cost of not going forward with a project or the cash outflows that will not be earned as a result of utilizing an asset for another alternative. For example, the opportunity cost of Newco’s new addition considered above is the cost of the land on which the company is considering putting the new plant addition. As such, it should be included in the analysis of the project.
In the consideration of incremental cash flows of a new project, there may be effects on the existing operations of the company to consider, known as “externalities.” For example, the addition to Newco’s plant is for the purpose of producing a new product. It must be considered whether the new product may actually take away or add to sales of the existing product.
Cannibalization is the type of externality where the new project takes sales away from the existing product.
Changes in Net Working Capital
A change in net working capital is essentially the changes in current assets minus changes in current liabilities. Within the capital-budgeting process, a project typically adds to current assets given additional inventories or potential increases in accounts receivables from new sales. The increases to current assets, however, are offset by current liabilities needed to finance the new project.
Overall, there may be a change to net working capital from the new project.
- If the change in net working capital is positive, the change to current assets outweighs the change in the current liabilities.
- If, however, the change in net working capital is negative, the change to current liabilities outweighs the change in current assets.
Read more: Incremental Cash Flows http://www.investopedia.com/walkthrough/corporate-finance/4/capital-investment-decisions/incremental-cash-flows.aspx#ixzz4r14adzv2
Follow us: Investopedia on Facebook