Dear Financial gurus,
I am taking liberty of picking your brains with reference to the cash flow example explained below.
Here it shows that some projects require (like expansion project in this example), net working capital as initial cash outflow. This working capital could be through addition of receivables and inventories along with raising short term liabilities. My question is that while initial capital outlay is depreciated and final cash inflow includes depreciated capital asset however this example along with several others required that that same amount of working capital which was taken as an initial outflow during the first year should be taken out as inflow during the terminal year. For example, if we have put (US$ 30,000) as initial working capital outflow into the project, the same amount of US$ 30,000 inflow should be registered during the terminal year. In the example below too, the net working capital of US$ 300 is returned exactly, why is this so? I mean cash flow through operations are variable, capital cash flow also changes, then why working capital must be returned exactly with the same value in the equation?
Example from Investopedia
Capital Investment Decisions - Project Cash Flows
When beginning capital-budgeting analysis, it is important to determine a project’s cash flows. These cash flows can be segmented as follows: 1. Initial Investment Outlay These are the costs that are needed to start the project, such as new equipment, installation, etc. 2. Operating Cash Flow over a Project’s Life This is the additional cash flow a new project generates. 3. Terminal-Year Cash Flow This is the final cash flow, both the inflows and outflows, at the end of the project’s life; for example, potential salvage value at the end of a machine’s life. Example: Expansion Project Newco wants to add to its production capacity and is looking closely at investing in Machine B. Machine B has a cost of $2,000, with shipping and installation expenses of $500 and a $300 cost in net working capital. Newco expects the machine to last for five years, at which point Machine B will have a book value (BV) of $1,000 ($2,000 minus five years of $200 annual depreciation) and a potential market value of $800. With respect to cash flows, Newco expects the new machine to generate an additional $1,500 in revenues and costs of $200. We will assume Newco has a tax rate of 40%. The maximum payback period that the company has established is five years. Let’s calculate the project’s initial investment outlay, operating cash flow over the project’s life and the terminal-year cash flow for the expansion project.
Answer: Initial Investment Outlay : Machine cost + shipping and installation expenses + change in net working capital = $2,000 + $500 + $300 = $2,800 Operating Cash Flow: CFt = (revenues - costs)*(1 - tax rate) CF1 = ($1,500 - $200)*(1 - 40%) = $780 CF2 = ($1,500 - $200)*(1 - 40%) = $780 CF3 = ($1,500 - $200)*(1 - 40%) = $780 CF4 = ($1,500 - $200)*(1 - 40%) = $780 CF5 = ($1,500 - $200)*(1 - 40%) = $780 Terminal Cash Flow:
Tips and Tricks The key metrics for determining the terminal cash flow are salvage value of the asset, net working capital and tax benefit/loss from the asset.
The terminal cash flow can be calculated as illustrated: Return of net working capital +$300 Salvage value of the machine +$800 Tax reduction from loss (salvage < BV) +$80 Net terminal cash flow $1,180 Operating CF5+$780 Total year-five cash flow $1,960 For determining the tax benefit or loss, a benefit is received if the book value of the asset is more than the salvage value, and a tax loss is recorded if the book value of the asset is less than the salvage value.