CHAPTER 8 Capital Budgeting Cash Flows 361
operating cash inflows
The incremental after-tax cash
inflows resulting from implemen-
tation of a project during its life.
terminal cash flow
The after-tax nonoperating cash
flow occurring in the final year of
a project. It is usually attribut-
able to liquidation of the project.
initial investment
The relevant cash outflow for a
proposed project at time zero.
0
$50,000
Initial
Investment
End of Year
10
$10,000
Terminal
Cash Flow
9
$9,000
8
$8,000
7
$8,000
6
$8,000
Operating
Cash Inflows
5
$7,000
4
$7,000
3
$6,000
2
$5,000
1
$4,000
$25,000
FIGURE 8.3
Cash Flow Components
Time line for major cash flow
components
Major Cash Flow Components
The cash flows of any project having the conventional patterncan include three
basic components: (1) an initial investment, (2) operating cash inflows, and (3)
terminal cash flow. All projects—whether for expansion, replacement, renewal,
or some other purpose—have the first two components. Some, however, lack the
final component, terminal cash flow.
Figure 8.3 depicts on a time line the cash flows for a project. Theinitial invest-
mentfor the proposed project is $50,000. This is the relevant cash outflow at time
zero. Theoperating cash inflows,which are the incremental after-tax cash inflows
resulting from implementation of the project during its life, gradually increase
from $4,000 in its first year to $10,000 in its tenth and final year. Theterminal
cash flowis the after-tax nonoperating cash flow occurring in the final year of the
project. It is usually attributable to liquidation of the project. In this case it is
$25,000, received at the end of the project’s 10-year life. Note that the terminal
cash flow doesnotinclude the $10,000 operating cash inflow for year 10.
Expansion versus Replacement Cash Flows
Developing relevant cash flow estimates is most straightforward in the case of
expansion decisions.In this case, the initial investment, operating cash inflows,
and terminal cash flow are merely the after-tax cash outflow and inflows associ-
ated with the proposed capital expenditure.
Identifying relevant cash flows for replacement decisionsis more compli-
cated, because the firm must identify the incrementalcash outflow and inflows
that would result from the proposed replacement. The initial investment in the
case of replacement is the difference between the initial investment needed to
acquire the new asset and any after-tax cash inflows expected from liquidation of