Capital Budgeting Cash Flows Developing relevant cash flow

estimates is most straightforward

Relevant cash flows the
in the case of expansion
incremental cash outflows
decisions. In this case, the initial
(investment) and resulting
investment, operating cash inflows,
subsequent inflows associated with
and terminal cash flow are merely
a proposed capital expenditure
the after tax cash outflow and
Incremental cash flows the inflows associated with the
additional cash flows (outflows or proposed capital expenditure.
inflows) expected to result from a
Identifying relevant cash flows for
proposed capital expenditure
replacement decisions is more
Major Cash Flow Components complicated, because the firm
must identify the incremental cash
The cash flow of any project may outflow and inflows that would
include three basic components: result from the proposed
replacement.
1. Initial investment the
relevant cash outflow for a Relevant Cash Flows for
proposed project at time zero Replacement Decisions
2. Operating cash inflows
the incremental after tax
cash inflows resulting from
implementation of a project
during its life
3. Terminal cash flow the
after tax nonoperating cash
flow occurring in the final
year of a project. It is usually
attributable to liquidation of
the project

All projects whether for Actually, all capital budgeting

expansion, replacement or
renewal, or some other
purpose have the first two
components. Some, however,
lack the final component,
terminal cash flow.
Expansion vs Replacement
Decisions
decisions can be viewed as
replacement decisions.
Expansion decisions are
merely replacement
decisions in which all cash
flows from the old asset are
zero.
Sunk Costs and Opportunity
Costs
Sunk costs cash outlays that
have already been made (past
outlays) and therefore have no
effect on the cash flows relevant to
a current decision
Sunk costs should not be
included in a projects
incremental cash flows
Opportunity costs cash flows
that could be realized from the best
alternative use of an owned asset.
They therefore represent cash
flows that will not be realized as a
result of employing that asset in
the proposed project
Opportunity costs should be
included as a cash outflows
when one is determining a
projects incremental cash
flows
Finding the Initial Investment
The initial investment is calculated
by subtracting all cash inflows
occurring at time zero from all cash
outflows occurring at time zero.
Cost of new asset the net
outflow necessary to acquire a new
asset
Installation costs any added
costs that are necessary to place
an asset into operation
Installed cost of new asset the
cost of new asset plus its
installation costs; equal the assets
depreciable value
After Tax proceeds from sale
of old asset the difference
between the old assets sale
proceeds and any applicable taxes
or tax refunds related to its sale
Proceeds from sale of old asset
the cash inflows, net of any
removal or cleanup costs, resulting
from the sale of an existing asset
Tax on sale of old asset tax
that depends on the relationship
between the old assets sale price
and book value on existing
government tax rules
 Note that if there are no
installation costs and the firm
is not replacing an existing
asset, then the cost
(purchase price) of the new
asset, adjusted for any
change net working capital,
is equal to the initial
investment
After Tax Proceeds From Sale
of Old Asset
Book value the strict accounting
value of an asset, calculated by
subtracting its accumulated
depreciation from its installed cost
Recaptured depreciation the
portion of an assets sale price that
is above its book value and below
its initial purchase price
There are three possible tax
situations. The asset may be sold:
1. For more than its book value
2. For its book value
3. For less than its book value
Tax Treatment on Sales of
Assets
Finding the Operating Cash
Inflows
Benefits expected to result
from proposed capital
expenditures must be
measured on an after tax
basis because the firm will
not have the use of any
benefits until it has satisfied
the governments tax claims
All benefits expected from a
proposed project must be
measured on a cash flow
basis. Cash inflows represent
dollars that can be spent, not
merely accounting profits
Incremental operating
cash inflows are needed
because our concern is only
with the change in operating
cash inflows that result from
the proposed project
Finding the Terminal Cash Flow