Generally, we can classify incremental cash flows for projects as initial investment outlay, operating cash flow over the project's life, and terminal year cash flow.
Expansion Project Analysis
Initial investment outlay is the upfront costs associated with the project. Components are price, which includes shipping and installation (FCInv)and investment in net working capital (NWCInv).
outlay = FCInv + NWCInv
The investment in NWC must be included in the capital budgeting decision. The investment in net working capital is defined as the difference between the changes in non-cash current assets and changes in non-cash current liabilities (i.e., those other than short-term debt). Cash is excluded because it is generally assumed not to be an operating asset.
NWCInv = change in non-cash current assets - change in non-debt current liabilities = change in NWC
If NWCInv is positive, additional financing is required and represents a cash outflow because cash must be used to fund the net investment in current assets. (If negative, the project frees up cash, creating a cash inflow.) Note that at the termination of the project, the firm will expect to receive an end of project cash inflow (or outflow) equal to initial NWC when the need for the additional working capital ends.
After tax operating cash flows are the incremental cash flows over the capital asset's economic life.
CF = (S-C-D)(1-D)+D = (S-C)(1-T)+(TD)
EBIT = (S-C-D)
S=sales, C=cash operating costs, D=depreciation expense, T=marginal tax rate
Although depreciation is a non-cash operating expense, it is an important part of determining operating cash flow because it reduces the amount of taxes paid by the firm. We can account for depreciation either by adding it back to net income from the project (as in the first cash flow formula) or by adding the tax savings caused by depreciation back to the project's after tax gross profit (as in the second formula). In general, a higher depreciation expense will result in greater tax savings and higher cash flows. This means that accelerated depreciation methods will create higher after-tax cash flows for the project earlier in the project's life as compared to the straight-line method, resulting in a higher net present value for the project. Entress is not included in operating cash flow's for capital budgeting purposes because it is incorporated into the project cost of capital.
Terminal year after tax non-operating cash flows (TNOCF). At the end of the asset's life, there are certain cash inflows that occur. These are the after-tax salvage value and the return of the net working capital.
Sal(t) = pre-tax cash proceeds from sale of fixed capital
B(t) = Book value of the fixed capital sold
Replacement Project Analysis
There are a few key differences in the analysis of a replacement project versus an expansion project. In a replacement project analysis we have two:
1. Reflect the sale of the old asset in the calculation of the initial outlay:
2. Calculate the incremental operating cash flows as the cash flows from the new asset minus the cash flows from the old asset:
Change in cash flow= (change in sales-change in costs)(1-T)+change in (DT)
3. Compute terminal year not operating cash flow:
TNOCF = (Sal(t-new)-Sal(t-old)+NWCInv-T[(Sal(t-new)-B(t-new)-(Sal(t-old)-B(t-old)]