11 Zutter Smart MFBrief 15e ch11

Principles of Managerial Finance
Fifteenth Edition, Global Edition
Chapter 11
Capital Budgeting Cash
Flows
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Learning Goals (1 of 2)
LG 1 Discuss net and incremental cash flows, and describe
the three major types of net cash flows.
LG 2 Discuss replacement versus expansion decisions, sunk
costs and opportunity costs, and international capital
budgeting.
LG 3 Calculate the initial investment associated with a
proposed investment project.
LG 4 Discuss the tax implications associated with the sale of
an old asset.

Learning Goals (2 of 2)
LG 5 Find the operating cash flows associated with a
LG 6 Determine the terminal cash flow associated with a

11.1 Project Cash Flows (1 of 5)
• Net Cash Flows
– The net (or the sum of) incremental after-tax cash flows over
a project’s life
• Incremental Cash Flows
– The additional after-tax cash flows—outflows or inflows—
that will occur only if the investment is made

• Major Cash Flow Types
– Initial Investment
 The incremental cash flows for a project at time zero
– Operating Cash Flows
 The net incremental after-tax cash flows occurring each period
during the project’s life
– Terminal Cash Flows
 The net after-tax cash flow occurring in the final year of the
project

Figure 11.1 Major Net Cash Flow Types

• Replacement versus Expansion Decisions
– Expansion decisions include investments designed to
increase the capacity of a factory, to launch a product in a
new market, or to open a new location
 Identifying incremental cash flows along with developing net
cash flow estimates is relatively straightforward
– Replacement decisions are perhaps even more common
 The firm must decide whether to replace some asset that it
already owns with a new asset
 Identifying incremental cash flows for these sorts of investment
projects is more complicated because the firm must compare
the cash flows that result from the new investment to the cash
flows that would have occurred if no investment had been
made
Figure 11.2 Relevant Net Cash Flows for
Replacement Decisions

• Sunk Costs and Opportunity Costs
– Sunk Costs
 Cash outlays that have already been made (past outlays) and
cannot be recovered, whether or not the firm follows through
and makes an investment
 Sunk costs are irrelevant and should not be included in a
project’s incremental cash flows
– Opportunity Costs
 Cash flows that could have been realized from the best
alternative use of an owned asset
 Opportunity costs are relevant and should be included as part
of the cash flow projections when determining a project’s net
cash flows

Example 11.1 (1 of 2)
Jankow Equipment is considering enhancing its drill press
X12, which it purchased 3 years earlier for $237,000, by
retrofitting it with the computerized control system from an
obsolete piece of equipment it owns. The obsolete
equipment could be sold today for $42,000, but without its
computerized control system, it would be worth nothing.
Jankow is in the process of estimating the labor and
materials costs of retrofitting the system to drill press X12
and the benefits expected from the retrofit. The $237,000
cost of drill press X12 is a sunk cost because it represents
an earlier cash outlay.

It would not be included as a cash outflow when determining
the cash flows relevant to the retrofit decision. However, if
Jankow uses the computerized control system of the
obsolete machine, then Jankow will have an opportunity cost
of $42,000, which is the cash the company could have
received by selling the obsolete equipment in its current
condition. By retrofitting the drill press, Jankow gives up the
opportunity to sell the old equipment for $42,000. This
opportunity cost would be included as a cash outflow
associated with using the computerized control system.

• International Capital Budgeting and Long-Term
Investments
– Although managers use the same basic capital budgeting
principles for domestic and international projects, they must
address several additional factors when evaluating foreign
investment opportunities
– International capital budgeting differs from the domestic
version because
(1) cash outflows and inflows occur in a foreign currency
(2) foreign investments entail potentially significant political risk
– Firms can minimize both risks through careful planning
– Foreign Direct Investment
 The transfer of capital, managerial, and technical assets to a
foreign country
Matter of Fact
Who Receives the Most FDI?
FDI plays an important role in the U.S. economy. According
to the 2016 World Investment Report, global flows of FDI
totaled $1.8 trillion, the highest level since the global
economic and financial crisis began in 2008 and within 10%
of the 2007 peak.
As tends to be the case, the United States was the world’s
largest recipient of FDI, receiving $380 billion in FDI, and the
largest provider, investing $300 billion in countries around
the world. Hong Kong and mainland China were the second
and third largest recipients of FDI, receiving $175 billion and
$136 billion, respectively.
11.2 Finding the Initial Investment (1 of 5)
• Installed Cost of the New Asset

– Cost of the New Asset
 The cash outflow necessary to acquire a new asset
– Installation Costs
 Any added costs that are necessary to place the new asset
into operation
– Installed Cost of the New Asset
 The cost of the new asset plus its installation costs; equals the
asset’s depreciable value

Table 11.1 The Basic Format for Determining
Initial Investment
(1) Installed cost of the new asset =
Cost of the new asset
+ Installation costs
(2) After-tax proceeds from the sale of the old asset =
Proceeds from the sale of the old asset
±Tax on the sale of the old asset
(3) Change in net working capital
Initial Investment = (1) − (2) ± (3)

• After-Tax Proceeds from the Sale of the Old Asset

– Proceeds from the Sale of the Old Asset
 The before-tax cash inflow net of any removal costs that
results from the sale of the old asset and is normally subject to
some type of tax treatment
– Tax on the Sale of the Old Asset
 Tax that depends on the relationship between the old asset’s
sale price and its book value and on existing government tax
rules

• After-Tax Proceeds from the Sale of the Old Asset

– Book Value
 The asset’s value on the firm’s balance sheet as determined by
accounting principles
Book Value = Installed Cost of New Asset – Accumulated Depreciation (11.1)
– After-Tax Proceeds from the Sale of the Old Asset

 The difference between the old asset’s sale proceeds and any
applicable tax liability or refund related to its sale

Example 11.2
Hudson Industries, a small electronics company, acquired a
machine tool 2 years ago with an installed cost of $100,000. The
asset was not eligible for 100% bonus depreciation under current
tax law, so it was being depreciated under MACRS, using a 5-year
recovery period. Table 4.2 shows that under MACRS for a 5-year
recovery period, 20% and 32% of the installed cost would be
depreciated in years 1 and 2, respectively. In other words, 52%
(20% + 32%) of the $100,000 cost, or $52,000 (0.52 × $100,000),
would be the accumulated depreciation after 2 years. Substituting
into Equation 11.1, we get
Book value  $100,000  $52,000  $48,000
The book value of Hudson’s asset at the end of year 2 is therefore

$48,000.
Table 11.2 Tax Treatments for the Sales of
Assets
Tax case Definition Tax treatment Tax Consequence
Gain on the Portion of the sale All gains above book value 21% of gain is a tax
sale of asset price that is greater are taxed as ordinary income. liability.
than book value
Loss on the Amount by which If the asset is depreciable 21% of loss is a tax
sale of asset sale price is less and used in business, then savings.
than book value loss is deducted from
ordinary income.
Blank Blank If the asset is not depreciable 21% of loss is a tax
or is not used in business, savings.
then loss is deductible only
against capital gains.

The old asset purchased 2 years ago for $100,000 by
Hudson Industries has a current book value of $48,000.
What will happen if the firm now decides to sell the asset
and replace it? The tax consequences depend on the sale
price. Figure 11.3 depicts the taxable income resulting from
four possible sale prices in light of the asset’s initial purchase
price of $100,000 and its current book value of $48,000. The
tax consequences of each of these sale prices are described
in the following paragraphs.

The sale of the asset for more than its book value If
Hudson sells the old asset for $110,000, it realizes a gain of
$62,000 ($110,000 − $48,000). Technically, this gain is made
up of two parts: a capital gain and recaptured depreciation,
which is the portion of the sale price that is above book value
and below the initial purchase price. For Hudson, the capital
gain is $10,000 ($110,000 sale price − $100,000 initial
purchase price); recaptured depreciation is $52,000 (the
$100,000 initial purchase price − $48,000 book value).

The tax treatment of capital gains can be quite complex, so
to keep things simple we assume that the total gain above
book value of $62,000 is taxed at Hudson’s ordinary
corporate income tax rate of 21%, resulting in taxes of
$13,020 (0.21 × $62,000). Hudson would not have paid
these taxes had they not replaced the old equipment, so the
taxes are part of the incremental cash flows at time zero.
That is, the taxes constitute a portion of the replacement
project’s initial investment. In effect, the taxes raise the
amount of the firm’s initial investment in the new asset by
reducing the proceeds from the sale of the old asset.

If Hudson instead sells the old asset for $70,000, it
experiences a gain above book value (in the form of
recaptured depreciation) of $22,000 ($70,000 − $48,000), as
shown under the $70,000 sale price in Figure 11.3. This gain
is taxed as ordinary income. Because the firm is in the 21%
tax bracket, the taxes on the $22,000 gain are $4,620 (0.21
× $22,000). This amount in taxes should be used in
calculating the initial investment in the new asset.
The sale of the asset for its book value If Hudson sells the
old asset for $48,000, there is no gain or loss on the sale, as
Figure 11.3 shows. Because there is no gain or loss, there is
no incremental tax effect of the sale.
The sale of the asset for less than its book value If
Hudson sells the asset for $30,000, it experiences a loss of
$18,000 ($48,000 − $30,000), as shown under the $30,000
sale price in Figure 11.3. The firm may use the loss to offset
ordinary operating income, which saves the firm $3,780
(0.21 × $18,000) in taxes. And, if current operating earnings
are not sufficient to offset the loss, the firm may be able to
apply these losses to prior or future years’ taxes.

Figure 11.3 Tax Consequences from the
Sale of an Asset

• Change in Net Working Capital

– Net Working Capital
 The difference between the firm’s current assets and its
current liabilities
– Change in Net Working Capital
 The difference between the change in current assets and the
change in current liabilities

Matter of Fact
Ignoring Working Capital Can Kill the Bottom Line
The REL 2015 Working Capital Survey of the top 1000
companies in North America and Europe found that only 1%
of companies had improved their working capital
performance for the previous 3 years. Surprisingly, the
survey found that when not facing a crisis only a few
companies actively made an effort to manage working
capital. Not surprisingly, the survey found that this
indifference came at a cost: A significant number of
companies in the survey lost 15% or more of their EBIT due
to inefficient or nonexistent working capital management.

Example 11.4
Danson Company is expanding. Analysts expect that the
changes summarized in Table 11.3 will occur and will be
maintained over the life of the expansion. Current assets will
increase by $22,000, and current liabilities will increase by
$9,000, resulting in a $13,000 increase in net working capital.
This increase in net working capital is part of the initial cash
outflow required to begin the expansion project, so we treat it
as a cash outflow in calculating the initial investment.

Table 11.3 Calculation of Change in Net
Working Capital for Danson Company
Current account Change in balance Blank
Cash + $ 4,000 Blank
Accounts receivable + 10,000 Blank
Inventories + 8,000 Blank
(1) Current assets Blank + $22,000
Accounts payable + $ 7,000 Blank
Expense accruals + 2,000 Blank
(2) Current liabilities Blank + $ 9,000
Change in net working capital= (1) − (2) Blank + $13,000

• Calculating the Initial Investment

– A variety of tax and other considerations enter into the initial
investment calculation
– The following example illustrates calculation of the initial
investment according to the format in Table 11.1

Powell Corporation is trying to determine the initial
investment required to replace an old machine with a new
one. The new machine costs $380,000, and an additional
$20,000 will be necessary to install it. It will be depreciated
under MACRS, using a 5-year recovery period. The old
machine was purchased 3 years ago at a cost of $240,000
and was being depreciated under MACRS, using a 5-year
recovery period. The firm can sell the old machine for
$280,000. The firm expects that a $35,000 increase in
current assets and an $18,000 increase in current liabilities
will accompany the replacement, resulting in a $17,000
($35,000 − $18,000) increase in net working capital. The
firm’s tax rate is 21%.
The only component of the initial investment calculation that
is difficult to obtain is taxes. The tax consequences of the
sale of the old machine depend on the selling price relative
to the asset’s book value. To find the book value of the old
machine, use the depreciation percentages from Table 4.2
of 20%, 32%, and 19% for years 1, 2, and 3, respectively.
The book value is the difference between the original
$240,000 purchase price and the accumulated depreciation
over the 3 years that the asset was in use. The resulting
book value is
$240, 000  (0.20  0.32  0.19)  $240, 000   $69, 600

Powell Corporation realizes a gain of $210,400 ($280,000
− $69,600) on the sale. The total taxes on the gain are
$44,184 (0.21 × $210,400). Powell’s financial analysts
must subtract these taxes from the $280,000 sale price of
the old machine to calculate the after-tax proceeds from
its sale.
Substituting the relevant amounts into the format in Table
11.1 results in an initial investment of $181,184, which
represents the net cash outflow required at time zero.

Installed cost of new machine Blank Blank
Cost of new machine $380,000 Blank
+ Installation costs 20,000 Blank
Total installed cost Blank $400,000
− After-tax proceeds from the sale of the old machine Blank Blank
Proceeds from the sale of the old machine $280,000 Blank
− Tax on the sale of the old machine 44,184 Blank
Total after-tax proceeds Blank 235,816
+ Change in net working capital Blank 17,000
Initial investment Blank 181,184

11.3 Finding the Operating Cash Flows
(1 of 4)
• Interpreting the Term Cash Flows

– All costs and benefits expected from a proposed project
must be measured on a cash flow basis
 Cash outflows represent costs incurred by the firm, and cash
inflows represent dollars that the firm receives and can then
spend
 Cash flows generally are not equal to accounting profits

(2 of 4)
• Interpreting the Term After-Tax

– Cash flows that result from investment projects must be
measured on an after-tax basis because the firm will not
have the use of any cash flows until it has both satisfied the
government’s tax claims and captured the government’s tax
refunds, credits, or other tax breaks
– Firms can use only the after-tax cash flows to pay returns to
lenders and shareholders, so when making investment
decisions, analysts must take care to measure incremental
cash flows after taxes

(3 of 4)
• Interpreting the Term After-Tax

– A simple technique can convert after-tax net profits into
operating cash flows
 The calculation requires adding depreciation and any other
noncash charges (amortization and depletion) deducted as
expenses on the firm’s income statement back to net profits
after taxes
 Adding depreciation to profit simply recognizes that the profit
calculation requires firms to deduct an expense not tied to a
specific cash outlay
 Adding depreciation to after-tax profit “corrects” this issue and
provides a number that better matches the actual cash inflows
and outflows

Powell Corporation’s estimates of its revenue and expenses
(excluding depreciation and interest), with and without the proposed
new machine described in Example 11.5, are given in Table 11.4.
Note that both the expected usable life of the new machine and the
remaining usable life of the old machine are 5 years. The new
machine’s depreciable value is the sum of the $380,000 purchase
price and the $20,000 installation cost. The firm calculates annual
depreciation deductions on the new machine, using the MACRS
percentages based on a 5-year recovery period. The resulting
depreciation on this machine for each of the 6 years, as well as the
remaining 3 years of depreciation (years 4, 5, and 6) on the old
machine, are calculated in Table 11.5.

The income statement format in Table 11.6 illustrates how to
calculate the operating cash flows each year. Note that we
exclude interest because we are focusing purely on the
“investment decision.” The interest is relevant to the
“financing decision,” which we will address later in this text.
Because we exclude interest expense, “earnings before
interest and taxes” (EBIT) is equivalent to “net profits before
taxes,” and the calculation of “operating cash flow” (OCF) in
Table 11.6 is identical to the definition that we provided in
Chapter 4 (defined in Equation 4.3).

Substituting the data from Tables 11.4 and 11.5 into this
format and assuming a 21% tax rate, we get Table 11.7,
which demonstrates the calculation of operating cash flows
for each year for both the new and the old machines.
Because the new machine is depreciated over 6 years, the
analysis must be performed over the 6-year period to
account for all the tax benefits of depreciation. The resulting
operating cash flows appear in the final row of Table 11.7 for
each machine. The $4,200 year-6 operating cash inflow for
the new machine results solely from the tax benefit of its
year-6 depreciation deduction.

Table 11.4 Powell Corporation’s Revenue
and Expenses (Excluding Depreciation
and Interest) for New and Old Machines
Bl
With new machine With old machine

an
k
Expenses (excl. Expenses

Year Revenue depr. and int.) Year Revenue (excl. depr. and int.)
1 $2,520,000 $2,300,000 1 $2,200,000 $1,990,000
2 2,520,000 2,300,000 2 2,300,000 2,110,000
3 2,520,000 2,300,000 3 2,400,000 2,230,000
4 2,520,000 2,300,000 4 2,400,000 2,250,000
5 2,520,000 2,300,000 5 2,250,000 2,120,000

Table 11.5 Depreciation Expense for New
and Old Machines for Powell Corporation

Table 11.6 Calculation of Operating Cash
Flows Using the Income Statement Format
Revenue
− Expenses (excluding depreciation and interest)
Earnings before interest, taxes, depreciation, and amortization (EBITDA)
− Depreciation
Earnings before interest and taxes (EBIT)
− Taxes (rate = T)
Net operating profit after taxes [NOPAT = EBIT × (1 − T)]
+ Depreciation
Operating cash flows (OCF) (same as OCF in Equation 4.3)

Table 11.7 Calculation of Operating Cash Flows for
Powell Corporation’s New and Old Machines (1 of 2)

Table 11.7 Calculation of Operating Cash Flows for
Powell Corporation’s New and Old Machines (2 of 2)

(4 of 4)
• Interpreting the Term Incremental

– The final step in estimating the net operating cash flows for
a proposed replacement project is to calculate the
incremental cash flows
– The differences in cash flows that occur with the new
machines compared to cash flows that occurred with the old
machine are incremental cash flows

Table 11.8 demonstrates the calculation of Powell
Corporation’s net operating cash flows for each year of the
replacement project. The estimates of operating cash flows
developed in Table 11.7 for the new and old machines
appear in columns 1 and 2, respectively. Column 2 values
represent the amount of operating cash flows that Powell
Corporation will receive if it does not replace the old
machine. If the new machine replaces the old machine, the
firm’s operating cash flows for each year will be those shown
in column 1. Subtracting the old machine’s operating cash
flows from the new machine’s operating cash flows, we get
the net operating cash flows for the replacement project for
each year, shown in column 3.
These net operating cash flows represent the amounts by
which each respective year’s operating cash flow will change
as a result of the replacement project. For example, in year
1, Powell Corporation’s operating cash flow would increase
by $18,652 if the proposed project were undertaken. These
are the relevant cash flows that analysts should consider
when evaluating the benefits of making a capital budgeting
decision regarding the replacement of the old machine with
the new machine.

Table 11.8 Operating Cash Flows for
Powell Corporation
blank Operating cash flows
Year New machinea Old machinea Net OCF
1 $190,600 $171,948 $190,600 − $171,948 = $18,652
2 200,680 156,148 $200,680 − $156,148 = $44,532
3 189,760 136,820 $189,760 − $136,820 = $52,940
4 183,880 118,500 $183,880 − $118,500 = $65,380
5 183,880 102,700 $183,880 − $102,700 = $81,180
6 4,200 0 $ 4,200 − $ 0 = $ 4,200
From final row for respective machine in Table 11.7.

a

11.4 Finding the Terminal Cash Flow
(1 of 6)
• A project’s terminal cash flow is the cash flow resulting

from termination and liquidation of a project at the end of
its economic life
• It represents the after-tax cash flow, exclusive of operating
cash flows, that occurs in the final year of the project
– For replacement projects, analysts must take into account
the proceeds from both the new asset and the old asset
– The proceeds from the sale of the new and the old asset,
often called “salvage value,” represent the amount net of
any removal costs expected on termination of the project
– For expansion types of investment projects, the proceeds
from the old asset are zero
(2 of 6)
• Regardless of the project type, a change in new working

capital often takes place at the end of a project life, so this
incremental cash flow, too, must be included in the
terminal cash flow

Table 11.9 The Basic Format for
Determining Terminal Cash Flow
(1) After-tax proceeds from the sale of the new asset =
Blank
Proceeds from the sale of the new asset

Bl
± Tax on the sale of the new asset

an
k
(2) After-tax proceeds from the sale of the old asset =

Blank
Proceeds from the sale of the old asset

Blank
± Tax on the sale of the old asset

(3) Change in net working capital
Bl
Terminal cash flow = (1) − (2) ± (3)

an
k

(3 of 6)
• After-Tax Proceeds from the Sale of the New and Old

Assets
– When the investment being analyzed involves replacing an
old asset with a new one, two elements are key in finding
the terminal cash flow
 First, at the end of the project’s life, the firm will dispose of the
new asset, possibly by selling it, so the after-tax proceeds from
selling the new asset represent an incremental cash inflow
 However, remember that if the firm had not replaced the old
asset, the firm would have received proceeds from the sale of
the old asset at the end of the project (rather than counting
those after-tax proceeds at the beginning of the project
timeline as part of the initial investment)

(4 of 6)
• After-Tax Proceeds from the Sale of the New and Old

Assets
– When the investment being analyzed involves replacing an
old asset with a new one, two elements are key in finding
the terminal cash flow
 Because the firm no longer has the opportunity to obtain the
proceeds from selling the old machine at the end of the
project’s life, we must count as an incremental cash outflow
the after-tax proceeds that the firm would have received from
disposal of the old asset
 If the net proceeds from the sale exceed book value, a tax
payment shown as an outflow will occur
 When the net proceeds from the sale fall short of book value, a
tax benefit shown as a cash inflow will result
(5 of 6)

– When we calculated the initial investment, we took into
account any change in net working capital that is attributable
to the new asset
– Now, when we calculate the terminal cash flow, the change
in net working capital represents the reversion of any initial
net working capital investment
– Most often, this will show up as a cash inflow due to the
reduction in net working capital; with termination of the
project, the need for the increased net working capital
investment usually ends

(6 of 6)

– As long as no changes in working capital occur after the
initial investment, the amount recovered at termination will
equal the amount shown in the calculation of the initial
investment
– If working capital changes year to year as a firm expands or
contracts operations, then those changes should be
incorporated into the yearly operating cash flows
– Changes to working capital by themselves do not trigger
incremental taxes, so there are no tax consequences to
consider

Continuing with the Powell Corporation example, assume
that the firm expects to liquidate the new machine at the end
of its 5-year usable life, to net $50,000 after paying removal
and cleanup costs. Had the new machine not replaced the
old machine, the old machine would have been liquidated
after 5 years to net $10,000. The firm expects to recover its
$17,000 net working capital investment upon termination of
the project. The firm pays taxes at a rate of 21%.

From the analysis of the operating cash flows presented
earlier, we can see that the new machine will have a book
value of $20,000 (equal to the year-6 depreciation) after 5
years. The old machine would have been fully depreciated
and therefore would have a book value of zero after 5 years.
Because the sale price of $50,000 for the new machine is
below its initial installed cost of $400,000, but greater than its
book value of $20,000, the firm will pay taxes only on the
recaptured depreciation of $30,000 ($50,000 sale proceeds
− $20,000 book value). Applying the ordinary tax rate of 21%
to this $30,000 results in a tax of $6,300 (0.21 × $30,000) on
the sale of the new machine.

Its after-tax sale proceeds would therefore equal $43,700
($50,000 sale proceeds − $6,300 taxes). Because the old
machine would have been sold for $10,000 at termination,
which is less than its original purchase price of $240,000 and
above its book value of zero, it would have experienced a
taxable gain of $10,000 ($10,000 sale price − $0 book value).
Applying the 21% tax rate to the $10,000 gain, the firm would
have owed a tax of $2,100 (0.21 × $10,000) on the sale of
the old machine at the end of year 5. The firm’s after-tax sale
proceeds from the old machine would have equalled $7,900
($10,000 sale price − $2,100 taxes). Substituting the
appropriate values into the format in Table 11.9 results in the
terminal cash inflow of $52,800.
After-tax proceeds from the sale of the new machine Blank Blank
Proceeds from the sale of the new machine $50,000 Blank
− Tax on sale of the new machine 6,300 Blank
Total after-tax proceeds: new machine Blank $43,700
− After-tax proceeds from the sale of the old machine Blank Blank
Proceeds from the sale of the old machine $10,000 Blank
− Tax on the sale of the old machine 2,100 Blank
Total after-tax proceeds: old machine Blank 7,900
+ Change in net working capital Blank 17,000
Terminal cash flow Blank $52,800

11.5 Summarizing the Net Cash Flows
• The initial investment, operating cash flows, and terminal
cash flow together represent a project’s net cash flows
• We can view these cash flows as the net after-tax cash
flows attributable to the proposed project
• They represent, in a cash flow sense, how much better or
worse off the firm will be if it chooses to implement the
proposal
• With the cash flow estimates in hand, a financial manager
could then calculate the investment’s NPV or IRR using the
techniques covered in Chapter 10

Example 11.9
Below we depict the relevant net cash flows for Powell
Corporation’s proposed replacement project on a timeline.
Note that because Powell plans to sell the new asset at the
end of its 5-year usable life, the $4,200 year-6 operating cash
inflow calculated in Table 11.8 has no relevance; the terminal
cash flow effectively replaces this value in the analysis.

Personal Finance Example 11.10 (1 of 4)
After receiving a sizable bonus from her employer, Tina
Taylor is contemplating the purchase of a new car. She
believes that by estimating and analyzing the cash flows,
she could make a more rational decision about whether to
make this large purchase. Tina’s cash flow estimates for the
car purchase are as follows:
Negotiated price of new car $33,500
Taxes and fees on new car purchase $ 1,650
Proceeds from the sale of her old car $ 9,750
Estimated value of new car in 3 years $10,500
Estimated value of old car in 3 years $ 5,700
Estimated annual repair costs on new car 0 (in warranty)
Estimated annual repair costs on old car $ 400

Using the cash flow estimates, Tina calculates the initial
investment, operating cash flows, terminal cash flow, and a
summary of all cash flows for the car purchase.
Initial Investment Blank Blank
Total cost of new car Blank Blank
Cost of car $33,500 Blank
+Taxes and fees 1,650 $35,150
− Proceeds from the sale of old car Blank 9,750
Initial investment Blank $25,400

Operating Cash Flows Year 1 Year 2 Year 3
Cost of repairs on new car $ 0 $ 0 $ 0
− Cost of repairs on old car 400 400 400
Operating cash flows (savings) $400 $400 $400
Terminal Cash Flow: End of Year 3 Blank Blank Blank
Proceeds from the sale of new car $15,500 Blank Blank
− Proceeds from the sale of old car 5,700 Blank Blank
Terminal cash flow $ 9,800 Blank Blank
Summary of Cash Flows Blank

End of Year Cash Flow
0 −$25,400
1 + 400
2 + 400
3 + 10,200 ($400 + $9,800)

The cash flows associated with Tina’s car purchase decision
reflect her net costs of the new car over the assumed 3-year
ownership period, but they ignore the many intangible
benefits of owning a car. Whereas the fuel cost and basic
transportation service provided are assumed to be the same
with the new car as with the old car, Tina will have to decide
if the cost of moving up to a new car can be justified in terms
of other factors, such as the improved safety technology on
the new car.

Review of Learning Goals (1 of 6)
• LG 1
– Discuss net and incremental cash flows, and describe the
three major types of net cash flows.
 A project’s net cash flows are the net (or the sum of)
incremental after-tax cash flows over a project’s life
 The incremental cash flows represent the additional after-tax
cash flows—outflows or inflows—that will occur only if the
investment is made
 The three major net cash flow types of any project include (1)
an initial investment, (2) operating cash flows, and (3) terminal
cash flow
 The initial investment occurs at time zero, the operating cash
flows occur during the project’s life, and the terminal cash flow
occurs at the end of the project
• LG 2
– Discuss replacement versus expansion decisions, sunk
costs and opportunity costs, and international capital
budgeting.
 For replacement decisions, the differences between the cash
flows of the new asset and the old asset are incremental cash
flows
 Expansion decisions are viewed as replacement decisions in
which all cash flows from the old asset are zero
 When estimating relevant cash flows, ignore sunk costs and
include opportunity costs as cash outflows
 In international capital budgeting, currency risks and political
risks can be minimized through careful planning

• LG 3
– Calculate the initial investment associated with a proposed
investment project.
 The initial investment is the initial cash flow required, taking into
account the installed cost of the new asset, the after-tax proceeds
from the sale of the old asset, and any change in net working capital
 The after-tax proceeds from the sale of the old asset reduce the initial
investment required to launch an investment project
 Taxes on the sale of the old asset depend on the selling price relative
to the asset’s book value
 A gain or a loss can result from the sale of an asset, depending on
whether the asset sells for (1) more than book value, (2) book value,
or (3) less than book value
 The change in net working capital is the difference between the
change in current assets and the change in current liabilities expected
to accompany a given investment decision
• LG 4
– Discuss the tax implications associated with the sale of an
old asset.
 There is typically a tax implication from the sale of an old asset
 The tax implication depends on the relationship between its
sale price and book value and on existing government tax
rules
 Generally, if the old asset sells for more than its book value,
the difference is subject to a capital gains tax, and if the old
asset sells for less than its book value, the company is entitled
to a tax deduction equal to the difference

• LG 5
– Find the operating cash flows associated with a proposed
investment project.
 The operating cash flows are the sum of incremental after-tax
cash flows occurring each period during the project’s life
 The income statement format adds depreciation back to net
operating profit after taxes to calculate an investment’s annual
operating cash inflows
 The net cash flows for a replacement project are the difference
between the operating cash flows of the new project and those
of the old project

• LG 6
– Determine the terminal cash flow associated with a
 The terminal cash flow represents the after-tax cash flow
(exclusive of operating cash inflows) that is expected from
liquidation of a project
 It is calculated for replacement projects by finding the
difference between the after-tax proceeds from the sale of the
new and the old asset at termination and then adjusting this
difference for any change in net working capital
 Sale price and depreciation data are used to find the taxes and
the after-tax sale proceeds on the new and old assets
 The change in net working capital typically represents the
reversion of any initial net working capital investment

11 Zutter Smart MFBrief 15e ch11

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11 Zutter Smart MFBrief 15e ch11

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Principles of Managerial Finance

Fifteenth Edition, Global Edition

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• Installed Cost of the New Asset

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• After-Tax Proceeds from the Sale of the Old Asset

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• After-Tax Proceeds from the Sale of the Old Asset

Book Value = Installed Cost of New Asset – Accumulated Depreciation (11.1)

– After-Tax Proceeds from the Sale of the Old Asset

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The book value of Hudson’s asset at the end of year 2 is therefore

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• Change in Net Working Capital

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• Calculating the Initial Investment

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$240, 000  (0.20  0.32  0.19)  $240, 000   $69, 600

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Cost of new machine $380,000 Blank

+ Installation costs 20,000 Blank

Total installed cost Blank $400,000

Proceeds from the sale of the old machine $280,000 Blank

− Tax on the sale of the old machine 44,184 Blank

Total after-tax proceeds Blank 235,816

+ Change in net working capital Blank 17,000

Initial investment Blank 181,184

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• Interpreting the Term Cash Flows

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• Interpreting the Term After-Tax

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• Interpreting the Term After-Tax

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With new machine With old machine

Expenses (excl. Expenses

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