Components of Cash Flows

A typical investment will have three components of cash flows:

1. Initial investment

2. Annual net cash flows

3. Terminal cash flows

1. Initial investment

Initial investment is the net cash outlay in the period in which an asset is purchased. A major element of the initial investment is gross outlay or original value of the asset, which comprises of its cost (including accessories and spare parts) and freight and installation charges. Original value is included in the existing block of assets for computing annual depreciation. Similar types of assets are included in one block of assets. Original value minus depreciation is the assets book value. When an asset is purchased for expanding revenues, it may require a lump sum investment in net working capital also. Thus initial investment will be equal to: gross investment plus increase in the net working capital. Further, in case of replacement decisions, the existing asset will have to be sold if the new asset acquired. The sale of the existing asset provides cash inflow. The cash proceeds from the sale of the existing assets should be subtracted to arrive at the initial investment. We shall use the term Co to represent initial investment. In practice, a large investment project may comprise of a number of cost components and involve a huge initial net cash outlay.

2. Annual net cash flows

An investment is expected to generate annual flows from operations after the initial cash outlay has been made. Cash flows should always be estimated on an after tax basis. Some people advocate computing of cash flows before tax basis and discounting them at the before-tax discount rate to find net present value. Unfortunately, this will not work in practice since there does not exist an easy and meaningful way for adjusting the discount rate on a before-tax basis. We shall refer to the after-tax cash flows as net cash flows and use the terms C1, C2, C3…… respectively for in period 1, 2, 3………n. Net cash flow is simply the difference between cash receipts and cash payments including taxes. Net cash flow will mostly consists of annual cash flows occurring from the operation of an investment, but it is also be affected by changes in net working capital and capital expenditures during the life of the investment. To illustrate, we first take the simple case where cash flows occur only from operations. Let us assume that all revenues (sales) are received in cash and all expenses are paid in cash (obviously cash expenses will exclude depreciation since it is a not-cash expense). Thus, the definition of net flow will be:

Net cash flow = Revenue – Expense – Taxes

Notice that in equation taxes are deducted for calculating the after-tax flows. Taxes are computed on the accounting profit, which treats depreciation as a deductible expense.

3. Terminal cash flows

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

• Salvage value

Salvage value is the most common example of terminal flows. Salvage value may be defined as the market price of an investment at the time of its sale. The cash proceeds net of taxes from the sale of the assets will be treated as cash inflow in the terminal (last) year. As per the 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 in the depreciation base assets. In the case of a replacement decisions, in addition to the salvage value of the new investment at the end of its life, two other salvage values have to be considered:

1. The salvage value of the existing asset now (at the time of 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 not will increase the current cash inflow, or will decrease the initial cash outlay of the net assets. However, the firm will have to forgo its end-of-life salvage value. This means reduced cash inflow in the last year of the new investment. The effects of the salvage values of existing and new assets may be summarized as flows:

• Salvage value of the new asset. It will increase 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 of in the period in which the existing asset is sold.

Sometimes removal costs may have to be incurred to replace an existing asset. Salvage value should be computed after adjusting these costs.