Scribd
Upload
295 views2 pages

Capital Budgeting Incremental Cash Flows

The document discusses how to calculate incremental cash flows for a replacement decision. It explains that the analysis can be viewed as two separate decisions: 1) the net benefits of buying a new asset, and 2) the net benefits of keeping the old asset. The incremental cash flows are then the difference between the cash flows of the new asset and old asset. A table shows the initial investments, operating cash flows, and terminal values for the new asset, old asset, and their incremental cash flows. The key is to deduct the cash flows of keeping the old asset from the cash flows of the new asset.

Uploaded by

bobhamilton3489
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
295 views2 pages

Capital Budgeting Incremental Cash Flows

The document discusses how to calculate incremental cash flows for a replacement decision. It explains that the analysis can be viewed as two separate decisions: 1) the net benefits of buying a new asset, and 2) the net benefits of keeping the old asset. The incremental cash flows are then the difference between the cash flows of the new asset and old asset. A table shows the initial investments, operating cash flows, and terminal values for the new asset, old asset, and their incremental cash flows. The key is to deduct the cash flows of keeping the old asset from the cash flows of the new asset.

Uploaded by

bobhamilton3489
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 2

Capital Budgeting: Incremental Cash Flows

The analysis for a replacement decision is a bit trickier than that for an expansion project. In order to calculate the incremental cash flows pertaining to a
replacement decision, it is helpful to understand the nature of the analysis. We could take an alternate view of the analysis as two separate decisions –
once determining the net benefits of buying a new asset, and another determining the net benefits of keeping the old asset. Then it would only be
necessary to take the difference between the cash flows in order to determine the net advantage (or disadvantage) of replacing the asset. Viewing the
analysis in this fashion, we could identify all the cash flows attributable to each alternative.

Initial investment Operating cash flows Terminal value


New asset cash flows ‐ Cost of new asset + New asset operating cash + Proceeds, sale of new asset
‐ installation costs flows +/̶ tax or tax benefit on sale of new
‐ increase in net working capital asset
+ proceeds from sale of old asset + recovery of net working capital
+/̶ tax or tax benefit on sale of old asset
Old asset cash flows 0 + Old asset operating cash + Proceeds, sale of old asset
flows +/̶ tax or tax benefit on sale of old
asset
Incremental cash flows ‐ New asset initial investment New asset operating cash flows New asset terminal value
‐0 ̶ old asset operating cash flows ̶ old asset terminal value

The new asset cash flows are summarised in the first row of the table above. If we buy a new asset, the relevant costs will include the purchase cost,
installation costs and normally an increase in net working capital. However, associated with this alternative is the implication that we will sell off (at time 0)
the old asset, retaining the proceeds from sale, plus or minus any tax implications arising from that sale. These are all assumed to arise at time 0. In
addition, there will be operating cash flows which will arise over the life of the new asset as a consequence of the purchase. Then, at the end of the life of
the new asset, it will be sold, and we will receive an inflow equal to the salvage value. However, there may well be tax consequences which arise as a
consequence of the sale of the new asset. Furthermore, there will be a recovery of net working capital. These cash flows at the end of the useful life are
called the terminal value.

If we instead keep the old asset, then the cash flows will be as depicted in the second row of the above table. There will be no investment outlay (because
we already own the old asset, having purchased it long ago. We will earn operating cash flows, and then we will sell the asset and incur tax consequences at
the end of its life.
Recall that our incremental analysis requires us to take the difference between the new asset cash flows and the old asset cash flows. This is presented in
the third row of the above table. All the cash flows attributable to keeping the old asset are deducted from the new asset cash flows. Intuitively, we can
explain this as being that if we buy the new asset, we earn new operating and terminal value cash inflows, but forgo the opportunity to earn the old asset
operating cash flows and the old asset terminal value.

You might also like