Estimating Cash Flows
in Capital Budgeting Evaluations


Cash Outflows

Cash outflows associated with a capital budgeting proposal may take many forms, but here are a few typical cash outflows:

  1. Machinery and equipment
  2. Transportation and shipping expenses
  3. Installation expenses and technical adjustments to equipment
  4. Working capital
  5. Salvage value of disposals (deduct, since it is treated as a "trade-in")
  6. Tax paid on the salvage value of the disposal
  7. Land
  8. Buildings
  9. Spare parts and engine overhauls
  10. Startup costs
  11. Site preparation
  12. Feasibility studies
  13. Field investigation and development
  14. Product development
  15. Option lease and payments

It is possible that cash outflows can occur in any year of the equipment's life (overhaul of a machine's engine four years after purchasing a new machine, for example).  However, virtually all of the cash outflows will typically occur at the time of the asset's purchase.  (The time of purchase is typically referred to as "year 0" since "year 1" is one year after the purchase date, etc..)

Two comments should be made regarding the cash outflows.

  1. The U.S. government's Internal Revenue Service has a rule that states that "any cost necessary to get a machine set up and in working order is a part of the depreciable cost."  In other words, costs such as shipping and installation are to be added to the equipment's cost and the entire amount is to be depreciated.
  2. Working capital (#4 above) is gross working capital (another name for current assets), not net working capital (i.e., current assets - current liabilities).  The term, as used in the context of capital budgeting, usually refers to inventory that is necessary to support the new equipment.  Since inventory is not a fixed asset, it is not part of the depreciable cost.  Working capital is typically treated as a cash outflow at the beginning of the asset's life and as a cash inflow at the end of the asset's life.  In other words, we assume that we purchase the required inventory when the new fixed asset is purchased and the inventory is sold (or reduced to its previous level) when the fixed asset wears out.

Cash Inflows

Fixed assets are frequently purchased in order to reduce the costs of the company - that is, there are savings associated with the purchase of the new asset.  These savings may be in any of several areas.  For example:

  1. wages - the new machine may allow the company to replace existing workers
  2. energy - the new machine may use much less energy than the machine that it is replacing
  3. materials - the new machine may waste less material than the machine that it is replacing

However, by reducing the company's cost, purchase of the machine will tend to increase the company's taxable income.  In other words, the company may not get to keep all of the savings associated with buying and using the new machine - the government will take some of it away in the form of higher taxes.  We are interested in knowing how much of the savings we get to keep (after paying the higher taxes).

There are two ways of calculating these after-tax cash inflows:  a long way and a short way.  We'll cover the long way (to help explain what's going on) but suggest using the short way (because it's easier).

The long way to calculate after-tax cash inflows

Let's assume that purchase of a new fixed asset (cost = $30,000, useful life = 5 years) will allow the company to save $10,000 in costs annually.  For the sake of illustration, let's also assume that the company is in the 30% tax bracket and uses straight-line depreciation.

Here are the changes to the company, on both an accounting and a cash flow basis, for each year:

Accounting Basis Cash Flow Basis
  Change in Sales $0 $0
- Change in Costs ($10,000) ($10,000)
  Change in EBDT* $10,000 $10,000
- Change in Depreciation $6,000 $0
  Change in Taxable Income $4,000 $10,000
- Change in Taxes (@30%) $1,200 $1,200
  Change in Net Income $2,800 $8,800
+ Addback of Change in Depreciation $6,000 $0
  Change in After-tax Cash Flow $8,800 $8,800

* EBDT = earnings before depreciation and taxes

Notice that:

  1. purchasing the new fixed asset has no effect on sales; customers don't buy more just because the company purchases a new machine.
  2. a reduction in costs leads to an increase in income of the same amount
  3. depreciation is subtracted for the accounting statements; however, no money is paid out for depreciation, so nothing is subtracted for depreciation in the cash flow column.
  4. taxes are calculated after subtracting depreciation; in the cash flow column, this amount ($1,200) is also the amount of taxes that is physically paid to the government.

There is a difference of $6,000 between the two columns' values for change in net income ($2,800 vs. $8,800).  This difference is due to the fact that depreciation of $6,000 is subtracted in the accounting column but not in the cash flow column.  It is the cash flow of $8,800 that we are looking for.  (Notice in the cash flow column that we save $10,000, pay $1,200 of this in the form of higher taxes, and get to keep the remaining $8,800.)

We could calculate this amount as we have done in the cash flow column, but notice that this means that we must also calculate the accounting column in order to determine the amount of taxes to be paid.  So most analysts who use this method simply calculate the numbers in the accounting column, then add back the change in depreciation to the change in net income (as show above).  This allows us to move relatively quickly to the $8,800 after-tax cash flow that we are looking for.

The short way to calculate after-tax cash inflows

Let's now look at a shorter, and easier, way to calculate the $8,800 cash flow determined above.

We will separate the calculations into two parts:

  1. Savings - Let's ignore, for the moment, the effect of depreciation on the cash flow and focus solely on the savings.  If we save $10,000 per year by lowering our costs, then our taxable income will go up by $10,000.  If we are in the 30% tax bracket, the government will charge us $3,000 in higher taxes (i.e., $10,000 * 30%).  We get to keep the remaining $7,000.  In more generic terms, our cash inflow is:
                                     cash flow =  savings * (1 - tax rate).
                                     cash flow = $10,000 * (1 - 0.30).
                                     cash flow =           $7,000
  1. Change in depreciation - Now let's ignore the savings and focus solely on the effect that the change in depreciation has on the cash flow.  Since we are in the 30% tax bracket, we will save $0.30 in taxes for every additional $1.00 that we deduct.  In more generic notation, our cash inflow is:
                                       cash flow = change in depreciation * tax rate
                                       cash flow = $6,000 * 0.30
                                       cash flow =         $1,800

Adding the two effects together, we have:

Cash Inflow =  savings * (1 - tax rate)  +  change in depreciation * tax rate
Cash Inflow = $10,000 * (1 - 0.30)  +  $6,000 * 0.30
Cash Inflow =              $7,000           +           $1,800
Cash Inflow =                               $8,800

So, if you just memorize this little equation, you'll find it fairly easy to calculate the project's cash inflow:

         Cash Inflow =  savings * (1 - tax rate)  +  change in depreciation * tax rate

Terminal cash flows

In addition to the "normal" cash inflows, there are a few "unusual" cash flows that occur in the last year of the project's life.  These are typically called terminal cash flows because they occur at the termination, or end, of the project's life.

These terminal cash flows typically are:

  1. salvage value of the asset being purchased (a cash inflow)
  1. tax on the sale of the asset when it is worn out (a cash outflow, usually)
  1. working capital (a cash inflow).  Remember that we said earlier that the additional inventory would be sold when the asset that it supports wears out and is disposed of.

These terminal cash flows are added to the normal cash inflow for the last year of the project's life.

Other Significant Cash Flow Issues

  1. Sunk Costs - Costs that have been incurred in the past and cannot be recovered are not relevant to the analysis.  These costs are called sunk costs.  The only cash flows that matter are those that will change if we decide to accept the project.  These cash flows are called incremental cash flows (or relevant cash flows).

For more details, follow this link on sunk costs.

  1. Inflation - With the passage of time, inflation will have an impact on the cash flows (e.g., wage rates will likely increase in the future as a result of inflation).  Should the cash flows be adjusted for the impact of inflation?  The answer is:  You have to be consistent in the relationship between the discount rate and the cash flows.
  1. If the discount rate includes an inflation premium (as it almost always will), then the cash flows should reflect the impact of inflation as well.
  1. If the cash flows do not include the impact of inflation, then the inflation rate should be deducted from the discount rate.

For more details, follow this link on how to treat inflation in a capital budgeting analysis.

  1. Loan Payments - What about the cash flows associated with financing the project, e.g., principal and interest payments on a loan that is used to finance the project?  Should these cash flows be included in the analysis along with the operating cash flows?

The answer is "no".  The whole purpose of conducting a capital budgeting analysis is to see if the operating cash flows are large enough to repay us for (1) the amount of money spent for the asset (i.e., the initial investment), (2) our financing cost, and (3) an extra return to cover the risk inherent in our estimates of future cash flows (i.e., the risk premium).  The financial costs are captured in the hurdle rate and do not need to be considered again by showing the individual payments on the debt or financing vehicle.

For more details, read this section on cash flows associated with financing the project.

Related Topics

Capital Budgeting Techniques

Managing Risk of Cash Flow Estimates in Capital Budgeting Decisions

Cash Flows Associated With Financing the Project

MACRS Depreciation Table