Figuring Out Profitability From Gross Sales And Expenses Taxes Formula Components of Cash Flows

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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

The initial investment is the net cash outlay during the period in which the asset is purchased. A major element of the initial investment is the gross outlay or original cost of the asset, which includes its cost (including accessories and spare parts) and rent and installation charges. The original value is included in the existing block of assets to calculate the annual depreciation. Assets of the same type are included in a block of assets. Original cost minus depreciation is the asset’s book value. When an asset is purchased to expand revenue, it may require a one-time investment in net working capital. Thus the initial investment will equal: gross investment plus increase in net working capital. Moreover, in the case of replacement decisions, the existing property will have to be sold if the new property is acquired. The sale of existing assets provides cash flow. Cash received from the sale of existing assets must be reduced to arrive at the initial investment. We will use the term to represent the initial investment. In practice, a large investment project may involve a number of cost components and involve a large initial net cash outlay.

2. Annual net cash flow

After the initial cash outlay, the investment is expected to generate annual cash flows from operations. Cash flow should always be estimated on an after-tax basis. Some people advocate computing cash flows before the tax basis and discounting at the pre-tax discount rate to find the net present value. Unfortunately, this does not work in practice as there is no easy and meaningful way to adjust the discount rate on a pre-tax basis. We will refer to the after-tax cash flow as net cash flow and use the terms C1, C2, C3…… for the periods 1, 2, 3………. respectively. Net cash flow is the difference between cash receipts and cash payments, including taxes. Net cash flow usually includes the annual cash flow from operations of the investment, but it is also affected by changes in net working capital and capital expenditures over the life of the investment. For example, we first take the simple case where cash flow is only from operations. Assume that all revenue (sales) is received in cash and all expenses are paid in cash (obviously cash expenses will exclude depreciation because it is a cash expense). Therefore, the definition of net flux will be:

Net Cash Flow = Revenue – Expenses – Taxes

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

3. Terminal cash flow

Additional inflows may occur in the final or terminal year of the investment.

• Salvage value

Salvage value is the most common example of a terminal flow. Salvage value can be defined as the market value of an investment at the time of its sale. Taxable cash proceeds from the sale of assets will be treated as cash flows in the terminal (past) year. As per the existing tax laws, no immediate tax liability (or tax saving) will arise on the sale of any asset as the value of the asset sold is adjusted to the depreciated base asset. In the case of a replacement decision, in addition to the salvage value of the new investment at the end of its life, two other salvage values ​​must be considered:

1. Salvage value of existing assets (at the time of replacement decision)

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

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

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

• Salvage value of existing assets. This will reduce the initial cash outlay of the new property.

• Salvage value of an existing asset at the end of its nominal life. This will reduce the cash flow of new investments during the period when existing assets are sold.

Sometimes removal costs may be incurred to replace existing property. Savings value should be calculated after adjusting these costs.

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