BFF2140 Chap.4 Project Cash Flows and Replacement
Project Cash Flows and Replacement
Project Cash Flows and Replacement converts accounting forecasts into incremental after-tax cash flows. Revenue, cash costs, depreciation tax effects, capital expenditure, working capital and terminal proceeds must be placed at their correct dates. Replacement analysis also includes the old asset's opportunity cost and after-tax sale effect rather than treating its book value as cash.
The key test is whether a cash flow changes because the project is accepted. Sunk costs fail that test, while foregone sale proceeds, side effects and changes in operating resources can be relevant. Depreciation is not itself cash, but it reduces taxable income and therefore creates a cash tax effect.
Increases in inventory or receivables commit working capital and are outflows; their recovery at the project's end is normally an inflow. Terminal analysis also includes after-tax disposal value and closure costs. Replacement questions compare buying the new asset with keeping the old one, so the old asset's current market value belongs in the time-zero difference even though its historical purchase price does not.
Financing charges are excluded from project free cash flow when the opportunity cost of capital already reflects financing. A well-structured forecast reconciles operating profit to cash, separates initial, operating and terminal sections, and discounts only after the complete incremental row has been audited.
What this chapter covers
- 01
Incremental cash flow
- 02
Sunk and opportunity costs
- 03
Depreciation tax shield
- 04
Working-capital investment
- 05
Terminal cash flow
- 06
Replacement analysis
- 07
Forecast reconciliation across initial investment, after-tax operations, working-capital commitment, disposal effects and recovery in the terminal year
Worked example · free
Build first-year free cash flow
- 3EBIT is $160,000 less $75,000 less $30,000, which equals $55,000; tax is $16,500 and NOPAT is $38,500.
- 3Add back $30,000 noncash depreciation and subtract the $12,000 working-capital increase to obtain $56,500.
Key terms
- Incremental cash flow
- The cash flow that occurs with the project and would not occur without it.
- Sunk cost
- A past cost that cannot be changed by the current decision.
- Terminal value
- The final-period cash flow from disposal, working-capital recovery and other project closure effects.
Project Cash Flows and Replacement FAQ
Why exclude sunk costs?
A sunk cost has already occurred and is identical whether the project is accepted or rejected. Because the decision cannot change it, including it would distort the comparison of future alternatives.
Why is working capital an outflow?
Extra inventory and receivables tie up cash that cannot be used elsewhere. The increase is an outflow when invested and is normally recovered as an inflow when the project ends.
How is replacement different from expansion?
Replacement considers both the new asset and the old asset being displaced. The old asset's sale proceeds, tax on sale and forgone future cash flows are incremental consequences of replacing it now.
Exam move
Organise project analysis around incremental cash rather than accounting labels. Set up columns for time 0, each operating year and the terminal year, then rows for revenue, cash costs, depreciation, taxable operating profit, tax, capital expenditure and changes in net working capital. Mark every forecast item with the question: does this cash flow change if the project is accepted?
Exclude sunk research already paid, include the market value of an asset used by the project as an opportunity cost, and include side effects on existing products when they are caused by the decision. Calculate operating tax from incremental EBIT, add depreciation back because it is noncash, and preserve the depreciation tax shield.
Treat an increase in working capital as an outflow when resources are committed and a recovery as an inflow when the project ends. Place after-tax sale proceeds and closure costs in the terminal column, not in an arbitrary operating year. Replacement decisions need two complete alternatives. Write the cash flows from keeping the old asset beside those from buying the new one, then subtract to obtain the replacement row.
The old purchase price is sunk, but its current sale price and associated tax effect are relevant. Use a reconciliation to check operating free cash flow by both the NOPAT-plus-depreciation route and the revenue-less-cash-costs-less-cash-tax route. Before discounting, total initial, operating and terminal sections separately so omissions are visible.
Practise scenarios in which book value, tax book value and market value differ, and state which one affects cash. Do not deduct interest within project cash flow when financing is already reflected in the discount rate. Keep nominal cash flows with a nominal rate and real cash flows with a real rate.
Maintain an error log for omitted working-capital recovery, wrong disposal-tax sign, sunk-cost inclusion and double-counted financing. Finish with an NPV decision plus a sensitivity comment on the largest uncertain driver. This structure earns reliability because another reader can trace every number from an operating assumption to the final cash-flow row.
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