A typical investment will have three components of cash flows:
1.Initial investment
2. Annual net cash flow
3. Cash Flow Terminal
1.Initial investment
The initial investment is the net outlay of cash in the period in which an asset is purchased. An important element of the initial investment is the gross outlay or original value of the asset, which includes its cost (including accessories and spare parts) and freight and installation charges. The original value is included in the existing block of assets 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 expand income, it may also require a global investment in net working capital. Thus the initial investment will be equal to: gross investment plus increase in net working capital. Also, in case of replacement decisions, the existing asset will need 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 may involve a number of cost components and involve a large initial outlay of net cash.
2. Annual net cash flow
An investment is expected to generate annual cash flows from operations after the initial cash outlay has been made. Cash flows should always be estimated after taxes. Some people advocate calculating the pre-tax cash flows 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 easy and meaningful way to adjust the pre-tax discount rate. We will refer to the 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 the annual cash flows that arise from the operation of an investment, but is also 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. Assume that all income (sales) is received in cash and all expenses are paid in cash (obviously, cash expenses will exclude depreciation, since it is not a cash expense). Thus, the definition of net flow will be:
Net Cash Flow = Income – Expenses – Taxes
Notice that taxes are deducted from the equation to calculate the after-tax cash flows. Taxes are calculated on accounting profit, which treats depreciation as a deductible expense.
3. Cash Flow Terminal
The last or final year of an investment may have additional flows.
• Rescue value
Salvage value is the most common example of terminal flows. Salvage value can be defined as the market price of an investment at the time of its sale. Net tax cash proceeds from the sale of the assets will be treated as cash inflows in the (last) terminal 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 depreciation basis. 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 asset now existing (at the time of the replacement decision)
2. The salvage value of the existing asset 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 outflow of 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 salvage values on existing and new assets can be summarized as flows:
• Salvage value of the new asset. It will increase the cash inflow in the terminal (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 that the existing asset is sold.
Sometimes removal costs may need to be incurred to replace an existing asset. The salvage value should be calculated after adjusting for these costs.