Principles of Managerial Finance

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