Capital Budgeting Cash Flows
Chapter Number Chapter 11
Subject COF
📖 Table of Contents
Outline
11.1 Project Cash Flows
MAJOR CASH FLOW TYPES
REPLACEMENT VERSUS EXPANSION DECISIONS
Expansion
Replacement
SUNK COSTS AND OPPORTUNITY COSTS
Example
INTERNATIONAL CAPITAL BUDGETING AND LONG-TERM
INVESTMENTS
11.2 Finding the Initial Investment
INSTALLED COST OF THE NEW ASSET
AFTER-TAX PROCEEDS FROM THE SALE OF THE OLD ASSET
Book Value
CHANGE IN NET WORKING CAPITAL
CALCULATING THE INITIAL INVESTMENT
11.3 Finding the Operating Cash Flows
INTERPRETING THE TERM CASH FLOWS
INTERPRETING THE TERM AFTER-TAX
Example: Using After-Tax Profit to Calculate Operating Cash Flows
INTERPRETING THE TERM INCREMENTAL
Example: Using Incremental Cash Flows to Calculate Operating Cash Flows
11.4 Finding the Terminal Cash Flow
AFTER-TAX PROCEEDS FROM SALE OF NEW & OLD ASSETS
CHANGE IN NET WORKING CAPITAL
EXAMPLE: CALCULATING TERMINAL CASH FLOWS
11.5 Summarizing the Net Cash Flows
EXAMPLE: TIMELINE OF REPLACEMENT PROJECT NET CASH FLOWS
PERSONAL FINANCE EXAMPLE
Capital Budgeting Cash Flows 1
, 11.1 Project Cash Flows
📍 A project’s net cash flows are the net (or the sum of) incremental after-tax cash flows over a
project’s life.
📍 The incremental cash flows represent the additional after-tax cash flows—outflows or inflows
—that will occur only if the firm makes the investment.
MAJOR CASH FLOW TYPES
The cash flows of any project may include:
1. an initial investment
2. operating cash flows
3. a terminal cash flow (Commonly a net inflow)
⚠️ total cash flows in year 10 are $35,000
The incremental cash flows that make up the initial investment typically include:
the cost of acquiring new assets
the proceeds from the disposal of the old assets
cash flows resulting from up-front changes to net working capital
The operating cash flows, which are the sum of incremental after-tax cash flows occurring each period
during the project’s life.
The terminal cash flow is a net after-tax cash flow occurring in the project’s final year.
REPLACEMENT VERSUS EXPANSION DECISIONS
Expansion
Identifying incremental cash flows along with developing net cash flow estimates is relatively
straightforward in these sorts of projects.
→ All cash flows are incremental: Because without expansion there would be no inflow or outflow
Capital Budgeting Cash Flows 2
, The initial investment, operating cash flows, and terminal cash flow are merely the net after-tax cash
flows associated with the proposed expansion project.
Replacement
Identifying incremental cash flows for these sorts of investment projects is more complicated because the
firm must compare the cash flows that result from the new investment to the cash flows that would have
occurred if no investment had been made.
SUNK COSTS AND OPPORTUNITY COSTS
When estimating the incremental cash flows
📍 Sunk costs are cash outlays that have already been made (past outlays) and cannot be
recovered, whether or not the firm follows through and makes an investment.
Sunk costs are irrelevant and should not be included in a project’s incremental cash flows.
📍 Opportunity costs are cash flows that could have been realized from the best alternative use of
an owned assets.
the incremental operating cash flows for a replacement project will be the difference between the new
operating cash flows and the forgone operating cash flows.
Example
Jankow Equipment is considering enhancing its drill press X12, which it purchased 3 years earlier for
$237,000, by retrofitting it with the computerized control system from an obsolete piece of equipment it
owns. The obsolete equipment could be sold today for $42,000, but without its computerized control
system, it would be worth nothing.
Jankow is in the process of estimating the labor and materials costs of retrofitting the system to drill press
X12 and the benefits expected from the retrofit. The $237,000 cost of drill press X12 is a sunk cost
Capital Budgeting Cash Flows 3
Chapter Number Chapter 11
Subject COF
📖 Table of Contents
Outline
11.1 Project Cash Flows
MAJOR CASH FLOW TYPES
REPLACEMENT VERSUS EXPANSION DECISIONS
Expansion
Replacement
SUNK COSTS AND OPPORTUNITY COSTS
Example
INTERNATIONAL CAPITAL BUDGETING AND LONG-TERM
INVESTMENTS
11.2 Finding the Initial Investment
INSTALLED COST OF THE NEW ASSET
AFTER-TAX PROCEEDS FROM THE SALE OF THE OLD ASSET
Book Value
CHANGE IN NET WORKING CAPITAL
CALCULATING THE INITIAL INVESTMENT
11.3 Finding the Operating Cash Flows
INTERPRETING THE TERM CASH FLOWS
INTERPRETING THE TERM AFTER-TAX
Example: Using After-Tax Profit to Calculate Operating Cash Flows
INTERPRETING THE TERM INCREMENTAL
Example: Using Incremental Cash Flows to Calculate Operating Cash Flows
11.4 Finding the Terminal Cash Flow
AFTER-TAX PROCEEDS FROM SALE OF NEW & OLD ASSETS
CHANGE IN NET WORKING CAPITAL
EXAMPLE: CALCULATING TERMINAL CASH FLOWS
11.5 Summarizing the Net Cash Flows
EXAMPLE: TIMELINE OF REPLACEMENT PROJECT NET CASH FLOWS
PERSONAL FINANCE EXAMPLE
Capital Budgeting Cash Flows 1
, 11.1 Project Cash Flows
📍 A project’s net cash flows are the net (or the sum of) incremental after-tax cash flows over a
project’s life.
📍 The incremental cash flows represent the additional after-tax cash flows—outflows or inflows
—that will occur only if the firm makes the investment.
MAJOR CASH FLOW TYPES
The cash flows of any project may include:
1. an initial investment
2. operating cash flows
3. a terminal cash flow (Commonly a net inflow)
⚠️ total cash flows in year 10 are $35,000
The incremental cash flows that make up the initial investment typically include:
the cost of acquiring new assets
the proceeds from the disposal of the old assets
cash flows resulting from up-front changes to net working capital
The operating cash flows, which are the sum of incremental after-tax cash flows occurring each period
during the project’s life.
The terminal cash flow is a net after-tax cash flow occurring in the project’s final year.
REPLACEMENT VERSUS EXPANSION DECISIONS
Expansion
Identifying incremental cash flows along with developing net cash flow estimates is relatively
straightforward in these sorts of projects.
→ All cash flows are incremental: Because without expansion there would be no inflow or outflow
Capital Budgeting Cash Flows 2
, The initial investment, operating cash flows, and terminal cash flow are merely the net after-tax cash
flows associated with the proposed expansion project.
Replacement
Identifying incremental cash flows for these sorts of investment projects is more complicated because the
firm must compare the cash flows that result from the new investment to the cash flows that would have
occurred if no investment had been made.
SUNK COSTS AND OPPORTUNITY COSTS
When estimating the incremental cash flows
📍 Sunk costs are cash outlays that have already been made (past outlays) and cannot be
recovered, whether or not the firm follows through and makes an investment.
Sunk costs are irrelevant and should not be included in a project’s incremental cash flows.
📍 Opportunity costs are cash flows that could have been realized from the best alternative use of
an owned assets.
the incremental operating cash flows for a replacement project will be the difference between the new
operating cash flows and the forgone operating cash flows.
Example
Jankow Equipment is considering enhancing its drill press X12, which it purchased 3 years earlier for
$237,000, by retrofitting it with the computerized control system from an obsolete piece of equipment it
owns. The obsolete equipment could be sold today for $42,000, but without its computerized control
system, it would be worth nothing.
Jankow is in the process of estimating the labor and materials costs of retrofitting the system to drill press
X12 and the benefits expected from the retrofit. The $237,000 cost of drill press X12 is a sunk cost
Capital Budgeting Cash Flows 3
