💸 1. Identifying Initial, Operating, and Terminal Cash Flows

Accurate project evaluation requires breaking cash flows into three time-based stages:

🔹 A. Initial Cash Flows (Time 0)

These occur before or at the start of the project and include:

Item Description
Capital Expenditures (CapEx) Purchase of fixed assets (e.g., plant, equipment, software)
Installation/Setup Costs One-time implementation or training costs
Initial Working Capital Investment Funds tied up in receivables, inventory, less payables
Opportunity Costs Value of using existing assets
Salvage of Old Equipment Proceeds from sale of replaced assets (net of tax)

🔁 Note: All relevant costs must be included, but sunk costs are excluded (costs already incurred and unrecoverable).

🔹 B. Operating Cash Flows (Years 1–N)

These are the periodic net cash flows during the project’s life:

Formula:

Operating Cash Flow (OCF)=EBIT+Depreciation/Amortization−Taxestext{Operating Cash Flow (OCF)} = text{EBIT} + text{Depreciation/Amortization} – text{Taxes}

Or:

OCF=Net Income+Non-Cash Charges+Changes in Working Capitaltext{OCF} = text{Net Income} + text{Non-Cash Charges} + text{Changes in Working Capital}

Key Components
Revenues from sales or services
Operating expenses (excluding depreciation)
Tax payments
Depreciation and amortization (non-cash but tax-deductible)
Changes in working capital

🔹 C. Terminal Cash Flows (Final Year)

Cash flows at the end of the project, including:

Item Description
Salvage Value After-tax proceeds from sale of assets
Recovery of Working Capital Release of previously invested working capital
Final Operating Cash Flow Last year’s OCF

🧾 Tax Effect on Salvage Value:

After-Tax Salvage=Sale Price−(Sale Price−Book Value)×Tax Ratetext{After-Tax Salvage} = text{Sale Price} – (text{Sale Price} – text{Book Value}) times text{Tax Rate}

🏗️ 2. Working Capital and Capital Expenditure Considerations

🔹 A. Working Capital

Working capital is cash tied up in operations. Projects often require upfront increases in working capital, which are recovered at the end.

Components Impact
Increase in A/R or Inventory Cash outflow
Increase in A/P or Accruals Cash inflow

📘 Rule: Include net change in working capital in each year’s OCF and reverse it in the final year.

🔹 B. Capital Expenditures (CapEx)

CapEx refers to the investment in long-term assets. It usually appears as:

  • Initial CapEx: Large outlay at time 0

  • Replacement CapEx: Mid-project upgrades or equipment replacements

These do not go in OCF directly but affect cash flow and depreciation (a tax shield).

📈 3. Inflation and Tax Effects on Cash Flows

🔹 A. Inflation Considerations

You must match cash flows and discount rates:

Scenario Correct Approach
Real cash flows Use real discount rate
Nominal cash flows (with inflation) Use nominal discount rate

🚫 Mixing nominal with real leads to wrong NPV.

🔹 B. Tax Effects

Tax significantly affects cash flows. Major considerations:

Tax Factor Effect
Corporate income tax Reduces after-tax earnings
Depreciation tax shield Increases cash flows
Capital gains tax on asset sale Reduces salvage value
Tax loss carryforward Delays tax payments (if allowed)

Depreciation Tax Shield:

Tax Shield=Depreciation×Tax Ratetext{Tax Shield} = text{Depreciation} times text{Tax Rate}

🧠 This can significantly improve cash flows for asset-heavy projects.

✅ Summary: Cash Flow Estimation Process

Step What to Do
1. Estimate initial outflows Include CapEx, installation, working capital
2. Forecast yearly operating flows Use revenues – costs – taxes + depreciation ± working capital
3. Calculate terminal flows Add salvage, recover working capital, and final OCF
4. Adjust for inflation and tax Use consistent rate and account for tax shields
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