Categories of Cash Flows

A capital investment project typically has three categories of cash flows: (1) the net initial investment in the project, which includes the acquisition of assets and any associated additions to working capital, minus the after-tax cash flow from the disposal of existing assets; (2) the after-tax cash flow from operations (including income tax cash savings from annual depreciation deductions) each year; and (3) the after-tax cash flow from disposing of an asset and recovering any working capital invested at the termination of the project. We use the Vector example to discuss these three categories.

As you work through the cash flows in each category, refer to Exhibit 22-6. This exhibit sketches the relevant cash flows for Vector’s decision to purchase the new bus as described in items 1–3 here. Note that the total relevant cash flows for each year equal the relevant cash flows used in Exhibits 22-2 and 22-3 to illustrate the NPV and IRR methods.

1. NET INITIAL INVESTMENT. Three components of net-initial-investment cash flows in the Vector example are (a) the cash outflow to purchase the hybrid bus, (b) the cash outflow for working capital, and (c) the after-tax cash inflow from the current disposal of the old bus.

1. 1a. INITIAL BUS INVESTMENT. These outflows, made for purchasing plant and equipment, occur at the beginning of the project’s life and include cash outflows for transporting and installing the equipment. In the Vector example, the $660,000 cost (including transportation and initial preparation) of the hybrid bus is an outflow in year 0. These cash flows are relevant to the capital budgeting decision because they will be incurred only if Vector decides to purchase the new bus.
2. 1b. INITIAL WORKING-CAPITAL INVESTMENT. Initial investments in plant and equipment are usually accompanied by additional investments in working capital. These additional investments take the form of current assets, such as accounts receivable and inventories, minus current liabilities, such as accounts payable. Working-capital investments are similar to plant and equipment investments in that they require cash. The magnitude of the investment generally increases as a function of the level of additional sales generated by the project. However, the exact relationship varies based on the nature of the project and the operating cycle of the industry. For a given dollar of sales, a maker of heavy equipment, for example, would require more working-capital support than Vector, which in turn has to invest more in working capital than a retail grocery store.
3. The Vector example assumes a $30,000 additional investment in working capital if the hybrid bus is acquired. The additional working-capital investment is the difference between the working capital required to operate the new bus ($36,000) and that required to operate the old bus ($6,000). The $30,000 additional investment, a consequence of the higher cost of replacement batteries and spare parts for the technologically advanced new bus, is a cash outflow in year 0 and is returned, that is, becomes a cash inflow, at the end of year 5.
4. 1c. AFTER-TAX CASH FLOW FROM CURRENT DISPOSAL OF OLD BUS. Any cash received from disposal of the old bus is a relevant cash inflow (in year 0) because it is a cash flow that differs between the alternatives of investing and not investing in the new bus. Vector will dispose of the old bus for $28,500 only if it invests in the new hybrid bus. Recall from Chapter 12 that the book value (which is original cost minus accumulated depreciation) of the old equipment is generally irrelevant to the decision because it is a past, or sunk, cost. However, when tax considerations are included, the book value does play a role because it determines the gain or loss on the sale of the bus and, therefore, the taxes paid (or saved) on the transaction.
5. Consider the tax consequences of disposing of the old bus. We first have to compute the gain or loss on disposal:

1. Any loss on the sale of assets lowers taxable income and results in tax savings. The after-tax cash flow from disposal of the old bus is as follows:

1. The sum of items 1a, 1b, and 1c appears in Exhibit 22-6 as the year 0 net initial investment for the new hybrid bus. It equals $648,900 (initial bus investment, $660,000, plus additional working-capital investment, $30,000, minus the after-tax cash inflow from current disposal of the old bus, $41,100).^*

2. CASH FLOW FROM OPERATIONS. This category includes the difference between each year’s cash flow from operations under the two alternatives. Organizations make capital investments to generate future cash inflows. These inflows may result from producing and selling additional goods or, as in the case of Vector, from savings in fuel, maintenance, and operating costs and the additional revenue from higher ticket prices as well as new customers who wish to take advantage of the greater comfort and accessibility of the hybrid bus. The annual cash flow from operations can be net outflows in some years. For example, Chevron periodically upgrades its oil extraction equipment, and when it does, the cash flow from operations tends to be negative for the site being upgraded. However, in the long run, the upgrades are NPV positive. Always focus on the cash flow from operations, not on revenues and expenses under accrual accounting.

1. Vector’s additional operating cash inflows—$220,000 in each of the first 4 years and $170,000 in the fifth year—are relevant because they are expected future cash flows that will differ depending on whether the firm purchases the new bus. The after-tax effects of these cash flows are described next.
2. 2a. ANNUAL AFTER-TAX CASH FLOW FROM OPERATIONS (EXCLUDING THE DEPRECIATION EFFECT). The 40% tax rate reduces the benefit of the $220,000 additional operating cash inflows for years 1 through 4 with the new hybrid bus. The after-tax cash flow (excluding the depreciation effect) is

1. For year 5, the after-tax cash flow (excluding the depreciation effect) is as follows:

1. Exhibit 22-6, item 2a, shows that the after-tax cash flows are $132,000 in each of years 1 through 4 and $102,000 for year 5.
2. To reinforce the idea about focusing on cash flows, consider the following additional fact about Vector. Suppose its total administrative costs will not change whether the company purchases a new bus or keeps the old one. The administrative costs are allocated to individual buses—Vector has several—on the basis of the costs of operating each bus. Because the new hybrid bus would have lower operating costs, the administrative costs allocated to it would be $25,000 less than the amount allocated to the bus it would replace. How should Vector incorporate the $25,000 decrease in allocated administrative costs in the relevant cash flow analysis?
3. To answer that question, we need to ask, “Do total administrative costs decrease at Vector Transport as a result of acquiring the new bus?” In our example, they do not. They remain the same whether or not the new bus is acquired. Only the administrative costs allocated to individual buses change. The administrative costs allocated to the new bus are $25,000 less than the amount allocated to the bus it would replace. This $25,000 difference in costs would be allocated to other buses in the company. That is, no cash flow savings in total costs would occur. Therefore, the $25,000 should not be included as part of the annual cash savings from operations.
4. Next consider the effects of depreciation. The depreciation line item is itself irrelevant in a DCF analysis. That’s because depreciation is a noncash allocation of costs, whereas DCF is based on inflows and outflows of cash. If a DCF method is used, the initial cost of equipment is regarded as a lump-sum outflow of cash in year 0. Deducting depreciation expenses from operating cash inflows would result in counting the lump-sum amount twice. However, depreciation results in income tax cash savings. These tax savings are a relevant cash flow. 
5. 2b. INCOME TAX CASH SAVINGS FROM ANNUAL DEPRECIATION DEDUCTIONS. Tax deductions for depreciation, in effect, partially offset the cost of acquiring the new hybrid bus. By purchasing the new bus, Vector is able to deduct $132,000 in depreciation each year, relative to the $12,000 depreciation on the old bus. The additional annual depreciation deduction of $120,000 results in incremental income tax cash savings of $\mathrm{\$}\text{120,000}\times 0.4$, or $48,000 annually. Exhibit 22-6, item 2b, shows these $48,000 amounts for years 1 through 5.^*
6. For economic-policy reasons, usually to encourage (or in some cases, discourage) investments, tax laws specify which depreciation methods and which depreciable lives are permitted. Suppose the government permitted accelerated depreciation to be used, allowing for higher depreciation deductions in earlier years. Should Vector then use accelerated depreciation? Yes, because there is a general rule in tax planning for profitable companies such as Vector: When there is a legal choice, take the depreciation (or any other deduction) sooner rather than later. Doing so causes the (cash) income tax savings to occur earlier, which increases a project’s NPV.

3. TERMINAL DISPOSAL OF INVESTMENT. The disposal of an investment generally increases cash inflow of a project at its termination. An error in forecasting the disposal value is seldom critical for a long-duration project because the present value of the amounts to be received in the distant future is usually small. For Vector, the two components of the terminal disposal value of the investment are (a) the after-tax cash flow from the terminal disposal of buses and (b) the after-tax cash flow from recovery of working capital.

1. 3a. AFTER-TAX CASH FLOW FROM TERMINAL DISPOSAL OF BUSES. At the end of the useful life of the project, the bus’s terminal disposal value is usually considerably less than the net initial investment (and sometimes zero). The relevant cash inflow is the difference in the expected after-tax cash inflow from terminal disposal at the end of 5 years under the two alternatives. Disposing of both the existing and the new bus will result in a zero after-tax cash inflow in year 5. Hence, there is no difference in the disposal-related after-tax cash inflows of the two alternatives.
2. Because both the existing and the new bus have disposal values that equal their book values at the time of their disposal (in each case, this value is $0), there are no tax effects for either alternative. What if either the existing or the new bus had a terminal value that differed from its book value at the time of disposal? In that case, the approach for computing the terminal inflow is identical to that for calculating the after-tax cash flow from current disposal illustrated earlier in item 1c.
3. 3b. AFTER-TAX CASH FLOW FROM TERMINAL RECOVERY OF WORKING-CAPITAL INVESTMENT. The initial investment in working capital is usually fully recouped when the project is terminated. At that time, inventories and accounts receivable necessary to support the project are no longer needed. Vector receives cash equal to the book value of its working capital. Thus, there is no gain or loss on working capital and, hence, no tax consequences. The relevant cash inflow is the difference in the expected working capital recovered under the two alternatives. At the end of year 5, Vector recovers $36,000 cash from working capital if it invests in the new hybrid bus versus $6,000 if it continues to use the old bus. The relevant cash inflow at the end of year 5 if Vector invests in the new bus is thus $30,000 $(\mathrm{\$}\text{36,000}-\mathrm{\$}\text{6,000}) .$

1.  Some capital investment projects reduce working capital. Assume that a ­computer-integrated manufacturing (CIM) project with a 7-year life will reduce inventories and, hence, working capital by $20 million from, say, $50 million to $30 million. This reduction will be represented as a $20 million cash inflow for the project in year 0. At the end of 7 years, the recovery of working capital will show a relevant incremental cash outflow of $20 million. That’s because, at the end of year 7, the company recovers only $30 million of working capital under CIM, rather than the $50 million of working capital it would have recovered had it not implemented CIM. 

Exhibit 22-6 shows items 3a and 3b in the “year 5” column. The relevant cash flows in Exhibit 22-6 serve as inputs for the four capital budgeting methods described earlier in the chapter.