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## Components of Cash Flows

A typical investment has three components of cash flow:

1. Initial investment

2. Annual net cash flow

3. Terminal cash flow

1. Initial investment

Initial investment is the net cash outlay during the period in which the asset is purchased. A major factor in the initial investment is the total outlay or the original value of the asset, including its cost (including accessories and spare parts) and freight and installation charges. The original value is included in the existing block of property to calculate the annual depreciation. A block of assets includes similar types of assets. The original cost minus depreciation is the book value of the asset. When assets are purchased to increase revenue, a lump sum investment in net working capital may also be required. Thus the initial investment will be equal to: total investment plus increase in net working capital. Further, in case of replacement decision, acquisition of new property may require sale of existing property. The sale of existing assets provides cash flow. Cash proceeds from the sale of existing assets should be deducted 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 multiple cost components and involve a large initial net cash outlay.

2. Annual net cash flow

The investment is expected to generate annual cash flows from operations after the initial cash outlay. Cash flow should always be estimated on an after-tax basis. Some advocate calculating cash flows on an after-tax basis and discounting at a pre-tax discount rate to find net present value. Unfortunately, this will not work in practice as there is no simple and meaningful way to adjust the discount rate on a pre-tax basis. We will refer to the after-tax cash flows as net cash flows and use the terms C1, C2, C3…… for periods 1, 2, 3………. respectively. Net cash flow is the difference between cash receipts and cash payments, including taxes. Net cash flow is primarily the annual cash flow from the investment’s operations, 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 are only from operations. Let us assume that all revenue (sales) is received in cash and all expenses are paid in cash (obviously cash expenses will exclude depreciation as it is a non-cash expense). Thus, the net flow is defined as:

Net Cash Flow = Revenue – Expenses – Taxes

Note that taxes are subtracted to calculate the after-tax flow in the equation. Taxes are calculated on accounting profits, which consider depreciation as a deductible expense.

3. Terminal cash flow

There may be additional inflows in the last or final year of the investment.

• Mortgage value

Salvage value is the most common example of a terminal flow. Salvage value can be defined as the market value of the investment at the time of sale. Taxable cash proceeds from the sale of property will be treated as cash proceeds in the terminal (last) year. Under existing tax laws, no immediate tax liability (or tax savings) will arise on the sale of an asset as the value of the asset sold is adjusted for depreciation in the original asset. In case of replacement decision, apart from the salvage value of the new investment at the end of its life, two other salvage values need to be considered:

1. Mortgage value of existing property (at the time of decision to transfer)

2. The salvage value of the existing asset at the end of its life, if it has not been replaced.

If an existing asset is replaced, its salvage value will not increase the current cash flows or reduce the initial cash outlay of the net asset. However, the firm has to sacrifice the end-of-life salvage value. This means that cash flow is reduced in the last year of new investment. The resulting flow of mortgage values of existing and new assets can be summarized as:

• The mortgage value of the new property. This will increase the cash flow in the terminal (end) period of the new investment.

• The mortgage value of the current property. This will reduce the initial cash cost of the new property.

• Salvage value of existing assets at the end of nominal life. The new investment will reduce the cash flow in the period in which the existing asset is sold.

Sometimes removal costs are incurred to replace existing assets. The mortgage value should be calculated after adjusting for these expenses.

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