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Explain about initial, incremental and terminal cash flows in finance management.
- Initial cash flows
Initial cash flow is the cash required to start a project or business. This cash is estimated mainly at planning stages of a business or a project. Fixed capital, working capital, salvage value, tax rate, and book value are considered, while calculating the initial cash flows. Sometimes, the decision for estimation of initial cash flow depends on profitability of a project or strategic purpose. Generally, initial cash flows are negative number because at a start of project or a business, there will be no returns.
Formula
Initial cash flows = FC+WC-S + (S-B) * T Here, FC = fixed capital, WC = working capital, S = Salvage value, B = Book value, T = Tax rate.
Incremental cash flows
Incremental cash flow is the additional cash flow for an organization. A positive cash flow indicates that there will be an increase in organization cash flows and chances for approving the project are high.
Sunk cost, opportunity cost, cannibalization and allocated cost makes calculation of incremental cash flow difficult. Market conditions, policies and legal constraints will also sometimes affect incremental cash flows. These cash flows act as deciding tool to accept or invest on a project. Initial investment, operating cash flow and terminal cash flows are components of an incremental cash flow.
Formula
Incremental cash flow = CI – ICO - E Here CI = Cash Inflow, E = Expenses and ICO = initial cash outflow
- Terminal cash flows
Terminal cash flows are cash flows at the end of the project, after all taxes are deducted. In other words, terminal cash flows are the net amount made by company after disposing the asset and necessary amounts are paid.
These are calculated after disposal of asset and all other amounts are paid (expenses, taxes etc.). With the help of these cash flows, company can get more information on financials of a project. Based on the financials, they can accept or reject.
Sometimes forecasting errors may lead to making wrong decisions, estimation of equipment may differ.
Formula
Terminal cash flow = Ta + ΔWC Terminal cash flow = Sp – T + ΔWC Terminal cash flow = (Sp – B) * (1-T) + ΔWC
Here, Ta = disposal (after tax), Sp = sales (pre tax) , T = Tax rate, ΔWC= change in working capital , B = Book value of asset.
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