Page 189 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes 11.1 Determining Project Cash Flow

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: 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

CF = (revenues - costs)*(1 - tax rate)
t
CF = ($1,500 - $200)*(1 - 40%) = $780
1
CF = ($1,500 - $200)*(1 - 40%) = $780
2
CF = ($1,500 - $200)*(1 - 40%) = $780
3
CF = ($1,500 - $200)*(1 - 40%) = $780
4
CF = ($1,500 - $200)*(1 - 40%) = $780
5
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

184 LOVELY PROFESSIONAL UNIVERSITY