Principles of Managerial Finance

Sixteenth Edition, Global Edition

Chapter 11
Capital Budgeting Cash Flows

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Learning Goals
LG 1 Discuss incremental cash flows and describe the three major
types of project cash flows.
LG 2 Discuss expansion versus replacement decisions, sunk costs,
opportunity costs, and financing costs.
LG 3 Calculate the initial cash flow associated with an investment
project.
LG 4 Discuss the tax implications associated with the sale of an old
asset.
LG 5 Find the periodic cash flows associated with an investment
project.
LG 6 Determine the terminal cash flow associated with an investment
project.

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11.1 Project Cash Flows n

• Project Cash Flows: the incremental free cash flows (after taxes) that a firm
expects a project to generate over its life:
Project cash flow = OCF – NFAI – NWCI (11.1)

• Operating Cash Flow (OCF): periodic incremental cash flows that most
projects generate by enabling the firm to produce and sell goods or services
OCF = [EBIT × (1 – T)] + Depreciation (11.2)

• Net Fixed Asset Investment (NFAI): investment made in fixed assets each
period, or equivalently, the change in gross fixed assets from one period to the
next way
Wars
NFAI = Change in net fixed assets + Depreciation (11.3)

• Net Working Capital Investment (NWCI): change in net working capital from
one period to the next

NWCI = Change in current assets – Change in current liabilities (11.4)

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11.1 Project Cash Flows u

• Initial Cash Flow

– The net incremental after-tax cash flow occurring at the beginning
of a project’s life (i.e., at time zero).
• Periodic cash flows
– The net incremental after-tax cash flow occurring each period
during a project’s life.
• Terminal cash flow
– The net incremental after-tax cash flow occurring at the end of a
project’s life.
• Terminal value
– The present value of a project’s estimated cash flows over an
infinite horizon.

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Figure 11.1 Typical Project Cash Flows to Identify
for a Capital Budgeting Project

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11.1 Project Cash Flows
n
• Incremental Cash Flows
– The additional after-tax cash flows–outflows or inflows–that will
occur only if an investment is made:
 First, forecast all cash flows that a firm will generate if it makes
a particular investment.
 Next, estimate the cash flows the firm will generate if it does
not make the investment.
 The investment’s incremental cash flow is just the difference
between those two sets’ of projections.

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11.1 Project Cash Flows n

• Incremental Cash Flows

– Incremental cash flows are easier to think about conceptually for
some projects than others
 Expansion
– Firm is making an investment that expands its activities by,
for example, building new manufacturing capacity, opening
new retail space, or launching a new product.
– In such a situation, the incremental cash flows are
exclusively the result of the expansion project.
– Incremental cash flow consists only of the new cash flows
generated by the investment.

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11.1 Project Cash Flows
• Incremental Cash Flows
– Incremental cash flows are easier to think about conceptually for
some projects than others
 Replacement
– A more difficult situation arises when a firm must decide
whether to replace some asset that it already owns with a
new asset, for example, by replacing old equipment,
upgrading computers or software, remodeling facilities, or
releasing new versions of older products.
– 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.

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11.1 Project Cash Flows
• Sunk Costs and Opportunity Costs n
– Sunk Costs
 Cash outflows that have already occurred (past outlays) and
cannot be recovered, regardless of the final investment
decision.
 Sunk costs are irrelevant and should not be included in a
project’s incremental cash flows.
– Opportunity Costs
 Cash flows that could have been realized from the best
alternative use of assets already in place.
 Opportunity costs are relevant and should be included as part
of the cash flow projections when determining a project’s net
cash flows.

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Example 11.1
Jankow Equipment is considering enhancing its drill press X12, which it
purchased three 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 because it represents an
earlier cash outlay. It would not be included as a cash outflow when determining
the cash flows relevant to the retrofit decision.

However, if Jankow uses the computerized control system of the obsolete

machine, then Jankow will have an opportunity cost of $42,000, which is the cash
the company could have received by selling the obsolete equipment in its current
condition. By retrofitting the drill press, Jankow gives up the opportunity to sell
the old equipment for $42,000. This opportunity cost would be included as a cash
outflow associated with using the computerized control system.

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11.1 Project Cash Flows
• Financing Costs
– Interest expenses and other financing costs are important, so we
must account for them in capital budgeting analysis.
– Discounting cash flows accomplishes this objective
 The discount rate itself accounts for the costs that firms must
pay lenders and shareholders for the capital they provide.
 Deducting interest expense separately from project cash flows
would be double counting them.
 Therefore, interest expense should not be included in the
calculation of incremental cash flows.

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Example 11.2
Hofstadter Sciences Inc. is considering a $40 million investment in land
that will never depreciate and will generate revenues of $6 million per
year in perpetuity. Partially offsetting those revenues are $2 million in
annual operating expenses. Hofstadter plans to finance this investment
by selling $20 million in stock that has a required return of 13% and $20
million in bonds that pay investors a 7% return. Thus, Hofstadter’s capital
structure weights are 50% debt and 50% equity.
Does this investment satisfy Hofstadter’s investors? For simplicity,
assume there are no taxes.

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Example 11.2
First, recognize that the company’s weighted-average cost of capital is 10%,
reflecting equal weights on the costs of equity and debt.

WACC = (0.50 × 13%) + (0.50 × 7%) = 10%

Suppose we calculate this project’s annual cash flow by deducting interest

expense. In that case, the investment produces an annual cash flow of $2.6
million.

Cash flow = revenue - operating expenses - interest expense

Cash flow = $6,000,000 – $2,000,000 – ($20,000,000 × 0.07)

= $2,600,000

If the project earns $2.6 million in cash flow each year in perpetuity, then its net
present value is negative, so the firm should not go forward with the investment.

NPV = -$40,000,000 + ($2,600,000 ÷ 0.10) = -$14,000,000

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Example 11.2
Suppose Hofstadter ignores the negative NPV and invests anyway. Does the
project bring in enough cash to satisfy investors?

Each year after paying operating expenses and interest expense, there is $2.6
million in extra cash. If Hofstadter pays that to shareholders as a dividend, it
represents a return on their $20 million investment of 13% ($2.6 million ÷ $20
million). That’s exactly the return that shareholders require, so both they and the
bondholders (who are receiving the promised 7% return) are satisfied.

If the project meets the expectations of both equity and debt investors, why does
it have a negative NPV?

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Example 11.2
The answer is that we should have excluded interest expense from the cash flow
calculation. With interest excluded, the project’s annual cash flow is $4 million
and its NPV is $0.

Annual cash flow = $6,000,000 - $2,000,000 = $4,000,000

NPV = -$40,000,000 + ($4,000,000 ÷ 0.10) = $0

Recall that a $0 NPV means that the project just satisfies all investors. This
example demonstrates how deducting the cost of financing (interest expense)
from the project cash flows understates the project’s value and sends managers
an incorrect signal to reject a good project. Thus, we should ignore the cost of
financing when determining project cash flows.

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11.2 Finding the Initial Cash Flow
• The initial cash flow nets all of the incremental cash flows that occur at
the start of the project, subtracting all the cash outflows from any cash
inflows.
• Installed Cost of the New Asset n
– Cost of the New Asset
 The cash outflow necessary to acquire a new asset.
– Installation Costs
 Any added costs that are necessary to place the new asset
into operation.
– Installed Cost of the New Asset
 The cost of the new asset plus its installation costs
 Equals the asset’s depreciable value.

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Table 11.1: A Template for Determining Initial
Cash Flow
(1) Installed cost of the new asset =
Cost of the new asset + Installation costs
(2) After-tax proceeds from the sale of the old asset =
Proceeds from the sale of the old asset
± Tax on the sale of the old asset
(3) Change in net working capital
Initial Cash Flow = (1) − (2) ± (3)

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11.2 Finding the Initial Cash Flow
• After-Tax Proceeds from the Sale of the Old Asset: the difference
between the old asset’s sale proceeds and any applicable tax liability
or refund related to its sale

After-tax proceeds from the sale of an asset =

Proceeds from the sale of an asset – [(Proceeds from the sale of an
asset – Book value) × Tax rate] (11.5)
b
g t
incaseloss
cost AC swing of a
initial pay
dep incase
of a loss

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11.2 Finding the Initial Cash Flow
• After-Tax Proceeds from the Sale of the Old Asset
– Proceeds from the Sale of an Asset
 The before-tax cash inflow net of any removal costs that results from
the sale of an old asset and is normally subject to some type of tax
treatment
– Tax on the Sale of an Asset
 Either an additional tax payment when the sale proceeds exceed the
asset’s book value or a tax refund when sale proceeds are less than
the asset’s book value.
– Book Value
 The asset’s value on the firm’s balance sheet as determined by
accounting principles.
 The difference between what an asset cost (including installation costs)
and the accumulated depreciation on the asset
Book Value = Installed Cost of Asset − Accumulated Depreciation (11.6)

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Example 11.3 w
Hudson Industries, a small electronics company, acquired a machine tool
two years ago with an installed cost of $100,000. The asset was not
eligible for 100% bonus depreciation under then-current tax law, so it was
being depreciated under MACRS, using a five-year recovery period.
Table 4.2 shows that under MACRS for a five-year recovery period, 20%
and 32% of the installed cost would be depreciated in years one and two,
respectively. In other words, 52% (20% + 32%) of the $100,000 cost, or
$52,000 ($100,000 × 0.52), would be the accumulated depreciation after
two years. Substituting into Equation 11.6, we get

Book value  $100, 000  $52, 000  $48, 000

The book value of Hudson’s asset at the end of year two is therefore
$48,000.

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Table 11.2 Tax Treatments for the Sales of
Assets
Tax case Definition Tax treatment Tax consequence

Gain on the sale of Portion of the sale All gains above book 21% of gain is a tax
asset price that is greater value are taxed as liability.
than book value ordinary income.

Loss on the sale of Amount by which sale If the asset is 21% of loss is a tax
asset price is less than book depreciable and savings.
value used in business,
then loss is
deducted from
ordinary income.

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Example 11.4
The old asset purchased two years ago for $100,000 by Hudson Industries has a
current book value of $48,000. What will happen if the firm now decides to sell
the asset and replace it?

The tax consequences depend on the sale price. We will consider the taxable
income resulting from three possible sale prices in light of the asset’s initial
purchase price of $100,000 and its current book value of $48,000. The tax
consequences of each of these sale prices are described in the following slides.

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Example 11.4 n
• The sale price of the asset is more than its book value
– If Hudson sells the old asset for $110,000, it realizes a gain of $62,000
($110,000 − $48,000).
– The tax treatment of capital gains can be quite complex, so to keep things
simple we assume that the total $62,000 gain is taxed at Hudson’s
ordinary corporate income tax rate of 21%, resulting in incremental taxes
of $13,020 ($62,000 × 0.21).
– Hudson would not have paid these taxes had they not replaced the old
equipment, so the taxes are part of the incremental cash flows at time
zero. That is, the taxes constitute a portion of the project’s initial
investment.

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Example 11.4 n
• The sale price of the asset equals its book value
– If Hudson sells the old asset for $48,000, there is no gain or loss on the
sale, as Figure 11.2 shows. Because there is no gain or loss, there is no
incremental tax effect of the sale.

• The sale price of the asset is less than its book value
– If Hudson sells the asset for $30,000, it experiences a loss of $18,000
($48,000 − $30,000). The firm may use the loss to offset ordinary
operating income, which saves the firm $3,780 ($18,000 × 0.21) in taxes.
And, if current operating earnings are not sufficient to offset the loss, the
firm may be able to apply these losses to prior or future years’ taxes.

Keep in mind that there are subtle opportunity costs here. If the firm makes an
investment that involves selling an old asset, it misses the opportunity to leave
that asset in service. Leaving it in service would generate two sources of cash
flow—periodic operating cash flow and cash flow from selling the old asset at
some future date at the end of its useful life. We will address both of these
opportunity costs later in this chapter.

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11.2 Finding the Initial Cash Flow
n
• Change in Net Working Capital
– Net Working Capital
 The difference between the firm’s current assets and its current
liabilities.
– Change in Net Working Capital
 The difference between the change in current assets and the
change in current liabilities (excluding changes in the short-
term or current portion of long-term debt.

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Matter of Fact
Inventory Management Lowers Working Capital Investment
Requirement for Large Firms
A 2019 survey by PwC found that for the first time since 2014, firms were
reducing their investments in net working capital, freeing up resources for
other uses. One of the drivers of lower working capital was improved
inventory management, especially among large firms. Compared to small
firms, large companies had 27.8 fewer days of inventory on hand, though
the gap between small and large firms was narrowing, suggesting that
smaller firms were increasing their focus on inventory management
techniques.

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Example 11.5 n
As part of an expansion project, Danson Company expects immediate increases
in certain current asset and liability accounts outlined in the table below. Current
assets will increase by $22,000, and current liabilities will increase by $9,000,
resulting in a $13,000 increase in net working capital. This increase in net working
capital increases the initial cash outflow required to begin the project.

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11.2 Finding the Initial Cash Flow
• Summary: Calculating the Initial Cash Flow
– An investment’s initial cash flow starts with the cost of acquiring
new assets, but as we have seen it may also include after-tax
proceeds from sales of old assets as well as changes in working
capital investment
– The following example includes all of these factors.

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Example 11.6 E
Powell Corporation is trying to determine the initial cash flow required to replace
an old machine with a new one capable of producing a higher rate of output. The
purchase price of the new machine is $380,000, and it costs $20,000 to install, so
its installed cost is $400,000. It will be depreciated under MACRS, using a five-
year recovery period. The old machine was purchased three years ago at a cost
of $240,000 and was being depreciated under MACRS, using a five-year
recovery period. The firm can sell the old machine for $280,000. Putting the new
machine into service will trigger an immediate $35,000 increase in current assets
and an $18,000 increase in current liabilities, resulting in a $17,000 ($35,000 −
$18,000) increase in net working capital. The firm’s tax rate is 21%.

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Example 11.6
4
The only component of the initial cash flow calculation that is difficult to obtain is
taxes. The tax consequence of the sale of the old machine depends on the
asset’s selling price relative to its book value. To find the old machine’s book
value, use the depreciation percentages from Table 4.2 of 20%, 32%, and 19%
for years 1, 2, and 3, respectively. The book value is the difference between the
original $240,000 purchase price and the accumulated depreciation. Equation
11.6 shows that the resulting book value is $69,600.

$240,000 – [$240,000 × (0.20 + 0.32 + 0.19)] = $69,600

Powell Corporation realizes a gain of $210,400 = ($280,000 − $69,600) on the

sale. The total taxes on the gain are $44,184 = ($210,400 × 0.21). Powell’s
financial analysts must subtract these taxes from the old machine’s $280,000
sale price to calculate the after-tax proceeds from its sale. Equation 11.5 puts this
all together to determine the after-tax proceeds from the sale of the old asset:

$280,000 – [($280,000 – $69,600) × 0.21] = $235,816

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Example 11.6
The new machine’s $400,000 installed cost less the after-tax proceeds from
selling the old machine equals Powell’s cash expenditure on fixed assets, while
the $17,000 increase in net working capital is a cash expenditure for net working
capital investment. Plug everything into Equation 11.1 to find the initial cash flow.

($400,000 – $235,816) + $17,000 = $181,184

Remember that this is a cash outflow, so the very first term of the overall project
NPV calculation will list the initial cash flow as -$181,184.
Blank

Cost of new machine $380,000

Blank

+ Installation costs 20,000

Blank

+ Installed cost of new machine $400,000

Blank

Proceeds from the sale of the old machine $280,000

Blank

− Tax on the sale of the old machine 44,184

Blank

− After-tax proceeds from the sale of the $235,816

old machine
+ Increase in net working capital Blank $ 17,000
Initial cash flow Blank $181,184

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11.3 Finding the Periodic Cash Flows
• After a firm makes a new investment, it will generate a stream of periodic cash
flows.

• A common way to make projections of these periodic cash flows is to build

year-by-year pro forma income statements over the investment’s life.

• Remember that what matters in deciding whether an investment creates or

destroys value is the investment’s cash flows, not its net income or earnings.

• Depreciation is a noncash expense, but it impacts cash flows because it

reduces taxes by an amount known as the depreciation tax shield. The
depreciation tax shield in any given year equals

Depreciation tax shield = depreciation expense × tax rate (11.7)

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11.3 Finding the Periodic Cash Flows
• There are two ways of handling depreciation expense when forecasting project
cash flows:
– (1) Deduct depreciation expense along with all other expenses when
calculating net income, and then add depreciation back because it was
not an actual outlay of cash.
– (2) Ignore depreciation when calculating net income, and then add the
depreciation tax shield.

• Either method captures the effect of depreciation on cash flow through tax
savings. The following example demonstrates the equivalence of these two
approaches.

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Example 11.7
Grove Microchip Manufacturing is purchasing new lithography equipment that it
will use to make computer processors. In its first year operating the new
equipment, Grove will sell $1 billion worth of chips, with a gross profit margin of
40%. Operating expenses (excluding depreciation and interest expense) equal
10% of sales, and the firm pays taxes based on a 21% rate. The equipment costs
$100 million, and under the tax law prevailing prior to 2018, Grove would have
been required to depreciate the equipment based on the five-year MACRS
schedule in Table 4.2. However, under the current tax law, the equipment is
eligible for 100% bonus depreciation, which means that Grove can depreciate the
full purchase price in the first year of operations.

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Example 11.7
To calculate the investment’s cash flow in the first year, Grove’s financial analysts
construct a pro forma income statement:

Year 1 ($ millions)
Sales $1,000
Cost of goods sold (60% of sales) -600
Gross profit $ 400
Operating expenses (10% of sales) -100
Depreciation -100
Pre-tax profit $ 200
Taxes (21%) -42
Net profit $ 158
Add back depreciation 100
Year 1 operating cash flow $ 258

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Example 11.7
The project’s cash flows equal $258 million in the first year. The final line of the
pro forma income statement adds back depreciation expense, recognizing that it
does not represent a cash outflow, which means that the $158 million net income
figure understates the cash flow that the project really produces. An alternative
way to produce the same cash flow ignores depreciation expense when
calculating net income and adds back the tax shield that depreciation provides,
as shown in the table below.

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Example 11.8
Powell Corporation’s estimates of its revenue and expenses (excluding
depreciation and interest), with and without the proposed new machine described
in Example 11.6, appear in Table 11.4 below. Whether Powell purchases the new
machine or not, it does not expect to make new investments in fixed assets or
working capital in the next five years. Both the expected usable life of the new
machine and the remaining usable life of the old machine are five years. The new
machine’s depreciable value is the sum of the $380,000 purchase price and the
$20,000 installation cost. The firm calculates annual depreciation deductions on
the new machine, using the MACRS percentages based on a five-year recovery
period. The resulting depreciation on this machine for each of the six years, as well
as the remaining three years of depreciation (years 4, 5, and 6) on the old
machine, are calculated in the table below.

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Table 11.5 Depreciation Expense for New and
Old Machines for Powell Corporation

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Example 11.8
The income statement format in Table 11.6 below provides a template for
calculating the operating cash flows each year. Table 11.7 applies that template
to Powell’s investment by combining the revenues and expenses from Table 11.4
with the depreciation charges in Table 11.5 to develop yearly pro forma income
statements for the investment. Table 11.7 shows the operating cash flow that
would result if Powell buys the new machine as well as the operating cash flow
that the company would generate if they do not invest and leave the old machine
in service. E

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Table 11.7 Calculation of Operating Cash Flows
for Powell Corporation’s New and Old Machines

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Table 11.7 Calculation of Operating Cash Flows
for Powell Corporation’s New and Old Machines

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11.3 Finding the Periodic Cash Flows
The final step in estimating the periodic cash flows for the investment
project is to calculate the incremental cash flows
– Incremental means the difference between the cash flows that the
firm produces with and without the new investment

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Example 11.9
Table 11.8 demonstrates the calculation of Powell Corporation’s incremental
periodic cash flows each year using the estimates of operating cash flows
developed in Table 11.7 for the new (column 1) and old (column 2) machines.
Column 2 values represent the amount of operating cash flows that Powell
Corporation would receive if it does not replace the old machine. If the new
machine replaces the old machine, the firm’s operating cash flows for each year
would be those shown in column 1. Subtracting the old machine’s cash flows
from those produced by the new machine, we get the investment’s incremental
operating cash flows for each year, shown in column 3.

For example, in year 1, Powell Corporation’s operating cash flow would increase
by $18,652 if it buys the new machine. These are the incremental operating cash
flows that analysts should consider when evaluating the benefits of replacing the
old machine with a new one.

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Table 11.8 Periodic Cash Flows for Powell
Corporation
Periodic cash flows

Year New machinea Old machinea Incremental periodic cash flow

1 $190,600 $171,948 $190,600 − $171,948 = $18,652

2 200,680 156,148 $200,680 − $156,148 = $44,532

3 189,760 136,820 $189,760 − $136,820 = $52,940

4 183,880 118,500 $183,880 − $118,500 = $65,380

5 183,880 102,700 $183,880 − $102,700 = $81,180

aFrom final row for respective machine in Table 11.7.

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11.4 Finding the Terminal Cash Flow
• An investment’s terminal cash flow typically takes one of two forms
1. The investment reaches the end of its useable life and is liquidated
2. The lifespan of the investment is indefinite, so there is no terminal cash
flow per se, but rather a terminal value that captures the net present
value of cash flows that an asset will produce over an infinite horizon

• When an investment project reaches the end of its life, the incremental cash
flow that comes from liquidating the investment in its final year of service is the
terminal cash flow
– May include original asset’s salvage value net of any removal or cleanup
costs as well as any previous working capital investments that the firm
recovers when the investment winds down
– If the original investment involved replacing an old asset with a new one,
the incremental terminal cash flow must take into account the proceeds
from liquidating the new asset net of any proceeds the firm might have
received had it kept the old asset in service and liquidated it instead.

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11.4 Finding the Terminal Cash Flow
• After-tax Proceeds From the Sale of New and Old Assets
– For an investment that involves replacing an old asset with a new one, the
incremental cash flow is the difference between the cash flow generated if
the firm invests in a new asset and the cash flow that it earns if it does not
invest.
– If the firm purchases a new asset, then at the end of its life, the firm sells
it and receives cash.
– If the firm does not invest, it continues to operate the original asset and
sells it at the end of its life
 The proceeds from this sale represent an opportunity cost to the firm
 The proceeds from selling the new asset at the end of its life are
reduced by this opportunity cost.

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Table 11.9 The Basic Format for Determining
Terminal Cash Flow

(1) After-tax proceeds from the sale of the new asset =

Blank

Proceeds from the sale of the new asset

Blank

± Tax on the sale of the new asset

(2) After-tax proceeds from the sale of the old asset =
Blank

Proceeds from the sale of the old asset

Blank

± Tax on the sale of the old asset

(3) Change in net working capital
Blank

Terminal cash flow = (1) − (2) ± (3)

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11.4 Finding the Terminal Cash Flow
• Change in Net Working Capital
– The initial cash flow calculation considers any change in net working
captial at the beginning of the project life.
– The terminal cash flow calculation includes any change in net working
captial that occurs at the end of the investment's life
 Most often, this will show up as a cash inflow as the firm depletes
inventories, collects accounts receivable, and pays accounts payable
when the project ends.
– As long as no changes in working capital occur after the initial cash flow,
the amount recovered at termination will equal what was invested up front
and shown in the initial cash flow.
– If working capital changes year to year as a firm expands or contracts
operations, then those changes should be incorporated into the yearly
operating cash flows.
– Changes to working capital by themselves do not trigger incremental
taxes, so there are no tax consequences to consider.

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Example 11.10
The Powell Corporation expects to liquidate the new machine after five years,
which brings in $50,000 after removal and cleanup costs. Had the new machine
not replaced the old one, the old machine would have been liquidated after five
years to net $10,000. This is an opportunity cost associated with Powell’s
investment decision. The firm expects to recover its $17,000 net working capital
investment upon termination of the project. The firm pays taxes at a rate of 21%.

From the depreciation schedule in Table 11.5, we see that Powell’s new machine
has not been fully depreciated after five years and has a book value remaining of
$20,000. The old machine would have been fully depreciated and therefore
would have had a book value of zero after five years.

Because the sale price of $50,000 for the new machine is greater than its book
value of $20,000, the firm will pay taxes the gain of $30,000 = ($50,000 sale
proceeds − $20,000 book value). Applying the ordinary tax rate of 21% to this
$30,000 results in a tax of $6,300 = ($30,000 × 0.21) on the sale of the new
machine.

The after-tax sale proceeds from the new machine = $43,700 = ($50,000 sale
proceeds − $6,300 taxes).

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Example 11.10 2
Because the old machine would have been sold for $10,000 at termination, which
is above its book value of zero, it would have experienced a taxable gain of
$10,000 ($10,000 sale price − $0 book value). Applying the 21% tax rate to the
$10,000 gain, the firm would have owed a tax of $2,100 ($10,000 × 0.21) on the
sale of the old machine at the end of year five.

The firm’s after-tax sale proceeds from the old machine = $7,900 = ($10,000 sale
price − $2,100 taxes).

Substituting the appropriate values into the format in Table 11.9 results in the
terminal cash inflow of $52,800.

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Example 11.10
n
Please configure the terminal cash flow calculation as follows:

Blank

Proceeds from the sale of the new machine $50,000

Blank

− Tax on sale of the new machine 6,300

Blank

+ After-tax proceeds from the sale of the new machine $43,700

Blank Blank

Blank

Proceeds from the sale of the old machine $10,000

Blank

− Tax on the sale of the old machine 2,100

Blank

− After-tax proceeds from the sale of the old machine $ 7,900

Blank

+ Change in net working capital $17,000

Blank

Terminal cash flow $52,800

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11.4 Finding the Terminal Cash Flow
E
• Finding the terminal value
– A different kind of terminal cash flow calculation is necessary for an
investment with an infinite life
 Fixed assets like equipment usually do not last for decades, but whole
companies do.
 When one firm buys another, the acquiring company usually expects
to operate the target company and generate cash flows from doing so
indefinitely.
– Analysts for the acquiring firm need to calculate the NPV of the proposed
acquisition over an infinite horizon
 Make annual cash flow forecasts for a relatively short period.
 Make an assumption about how the cash flows will grow in the years
after the forecast horizon.

e9

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11.4 Finding the Terminal Cash Flow
n
• Finding the terminal value
– Analysts for the acquiring firm need to calculate the NPV of the proposed
acquisition over an infinite horizon
 The investment’s terminal value (TV) is the present value of that
future cash flow stream.
 If analysts make annual cash flow projections for t years,
– TVt is the terminal value at time t
– CFt + 1 is the cash flow at time t times one plus the growth rate
– r is the discount rate
– g is the growth rate

𝐶𝐹
𝑇𝑉 = (11.8)
(𝑟 − 𝑔)

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Example 11.11
Nile.com is a large retail company that is considering the acquisition of a
smaller competitor, Bull’s Eye Inc. Financial analysts at Nile believe that
acquiring Bull’s Eye would require an up-front payment of $20 billion, and
they have estimated the acquisition’s incremental cash flows for the first
four years as shown below.

Year Cash Flow ($ millions)

0 - $20,000

1 650

2 900

3 1,200

4 1,500 n

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Example 11.11
Beyond the fourth year, analysts estimate that incremental cash flows will grow at
4% per year in perpetuity, and the appropriate discount rate for the acquisition is
10%.

To calculate the terminal value, recognize that in year 5 cash flows will be 4%
higher than in year 4, or $1.56 billion. Using Equation 11.8, the acquisition’s
terminal value is the present value in year 4 of all the cash flows arriving in year 5
and beyond, which is $26 billion.

$1,500 × (1 + 0.04)
𝑇𝑉 = = $26,000
0.10 − 0.04

Discounting the acquisition’s annual cash flow as well as its terminal value to the
present gives the overall NPV of just over $1 billion.
$650 $900 $1,200 $1,500 $26,000
𝑁𝑃𝑉 = −$20,000 + + + + +
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)
= $1,019

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11.5 Putting It All Together
• Most capital investments begin with an initial cash flow, produce
periodic cash flows from operating the asset, and end with a terminal
cash flow.
• Taken together, these are the project cash flows that analysts estimate
when assessing whether an investment project creates or destroys
value for investors

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Example 11.12
The timelines on the next slide illustrate the incremental cash flows necessary to
evaluate Powell Corporation’s investment decision. The first timeline depicts the
cash flows that the company will earn over the next five years if it makes no
investment and continues to operate the old machine. If the firm chooses to
invest, all of the cash flows on the first timeline become opportunity costs
because, by getting rid of the old machine and buying a new one, the firm
essentially gives up these cash flows.

The second timeline shows the cash flows resulting from an investment in new
equipment.

The third timeline shows the incremental cash flows from the investment, which
are simply the differences in cash flow each period between the first two
timelines.

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Example 11.12
n

With these project cash flow estimates in hand, a financial manager could
then calculate the investment’s NPV or IRR using the techniques covered in
Chapter 10.
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Example 11.13: Personal Finance
After receiving a sizable bonus from her employer, Tina Taylor is
contemplating the purchase of a new car. She believes that by estimating
and analyzing the cash flows, she could make a more rational decision
about whether to make this large purchase. Tina’s cash flow estimates
for the car purchase are as follows:

Negotiated price of new car $33,500

Taxes and fees on new car purchase $ 1,650
Proceeds from the sale of her old car $ 9,750
Estimated value of new car in three years $10,500 15500
Estimated value of old car in three years $ 5,700
Estimated annual repair costs on new car 0 (in warranty)
Estimated annual repair costs on old car $ 400

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Example 11.13: Personal Finance
Using the cash flow estimates, Tina calculates the initial cash flow,
periodic cash flows, terminal cash flow, and a summary of all cash flows
for the car purchase.

Blank Blank

Initial cash flow

Blank Blank

Total cost of new car

Blank

Cost of car $33,500

+Taxes and fees 1,650 $35,150
Blank

− Proceeds from the sale of old car 9,750

Blank

Initial investment $25,400

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Example 11.13: Personal Finance
Periodic Cash Flows Year 1 Year 2
2
Year 3
Cost of repairs on new car $ 0 $ 0 $ 0
− Cost of repairs on old car 400 400 400
inflo
Operating cash flows (savings) $400
Blank
$400Blank
$400 cash
Blank

Terminal Cash Flow: End of Year 3 Blank

Proceeds from the sale of new car Blank

$15,500
− Proceeds from the sale of old car Blank
5,700
Terminal cash flow $ 9,800

Summary of Cash Flows Blank

End of Year Cash Flow

0 −$25,400

1 inflow
+ 400

2 + 400

3 + 10,200 ($400 + $9,800)

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Example 11.13: Personal Finance
The cash flows associated with Tina’s car purchase decision reflect her
net costs of the new car over the assumed three-year ownership period,
but they ignore the many intangible benefits of owning a car. Whereas
the fuel cost and basic transportation service provided are assumed to
be the same with the new car as with the old car, Tina will have to decide
if the cost of moving up to a new car can be justified in terms of other
factors, such as the improved safety technology on the new car.

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