The cash flows for a conventional expansion project can be grouped into 1) the investment outlays, 2) after-tax operating cash flows over the project’s life, and 3) terminal year after-tax non-operating cash flows. Attached excel format gives an example of the cash flows for a capital project where all of the cash flows are collected by year.
The investment outlays include a 200,000 outlay for fixed capital items. This outlay includes 25,000 for no depreciable land, plus 175,000 for equipment that will be depreciated straight-line to zero over five years. The investment in net working capital is the net investment in short-term assets required for the investment. This is the investment in receivables and inventory needed, less the short-term payables generated by the project. In this case, the project required 50,000 of current assets but generated 20,000 in current liabilities, resulting in a total investment in net working capital of 30,000. The total investment outlay at time zero is 230,000.
Each year, sales will be 220,000 and cash operating expenses will be 90,000. Annual depreciation for the 175,000. depreciable equipment is 35,000 (one-fifth of the cost). The result is an operating income before taxes of 95,000. Income taxes at a 40 percent rate are 0.40 × 95,000 = 38,000. This leaves operating income after taxes of 57,000. Adding back the depreciation charge of $35,000 gives the annual after-tax operating cash flow of 92,000.6 At the end of Year 5, the company will sell off the fixed capital assets. In this case, the fixed capital assets (including the land) are sold for 50,000, which represent a gain of 25,000 over the remaining book value of 25,000. The gain of 25,000 is taxed at 40 percent, resulting in a tax of 10,000. This leaves 40,000 for the fixed capital assets after taxes. Additionally, the net working capital investment of 30,000 is recovered, as the short-term assets (such as inventory and receivables) and short- term liabilities (such as payables) are no longer needed for the project. Total terminal year non-operating cash flows are then 70,000. The investment project has a required rate of return of 10 percent. Discounting the future cash flows at 10 percent and subtracting the investment outlay gives an NPV of 162,217. The internal rate of return is 32.70 percent. Because the investment has a positive NPV, this project should be accepted. The IRR investment decision criterion would also recommend accepting the project because the IRR is greater than the required rate of return.