All typical investments have the following three types of cash flows −
The initial cost is the cost of assets in the beginning phase of a project. It is the net outlay in the given period when an asset is purchased.
Gross Outlay or Original Value (OV) is a major element of initial investment which includes the costs of accessories and spares, and freight and installation charges. The OV is included in the block of an asset to calculate the depreciation. Original value minus depreciation is the book value (BV) of the asset.
A lumpsum investment may also be part of the initial cost when an asset is purchased for expanding the revenues. Therefore, the initial investment is equal to gross investment plus an increase in net working capital.
In addition, there may be sales of existing assets in the case of a new project. The cost gained due to the sale of new assets should be subtracted to get the initial investments.
Once the initial investments are made, a project will start generating cash flows. As a rule of thumb, net cash inflows should always be calculated on an after-tax basis. Some people advocate using cash flows before tax and discounting them at the before-tax discount rate to find NPV which does not work in practice, as there is no meaningful way of calculating the discount rate in general.
The after-tax cash flows are often termed Net Cash Flows (NCF) which is nothing else but the difference between cash receipts and cash payments including the taxes. NCF mostly consists of the cash flows occurring from investments, but it is also influenced by changes in net working capital and capital expenditures during the lifetime of a project.
If all revenues are accepted in cash and all expenses are also paid in cash (depreciation will be excluded as it is a non-cash expense). Then we can write
𝐍𝐞𝐭 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰𝐬 = 𝐑𝐞𝐯𝐞𝐧𝐮𝐞𝐬 − 𝐄𝐱𝐩𝐞𝐧𝐬𝐞𝐬 − 𝐓𝐚𝐱𝐞𝐬
In the equation, taxes are deducted for calculating after-tax cash flows. Taxes are computed on accounting profit which treats depreciation as deductible expenses.
Terminal Cash Flows include depreciation and taxes.
A careful and accurate measure of non-cash items is necessary for computing the after-tax cash flows.
Depreciation is usually an allocation of the cost of an asset. It needs accounting entry and does not need a cash outflow.
The cash outflow usually occurs when an asset is acquired by the company. Tax deductions are calculated as per the income tax rules. It does not have any direct effect on cash flow but indirectly affects the cash flow through the tax liability of the firm.
The saved cash flow for taxes is an inflow of cash, and the savings resulting from depreciation is known as the depreciation tax shield of the investment project.