Module 20.1 LOS 20.a: Expansion/Replacement Project Initial Cash Outlay Calculation

Capital projects can be broken down into three main incremental cash flows, the initial investment outlay, the operating cash flows over the project life and the terminal year cash flow.

Initial investment outlay is the up-front costs associated with the project. It’s made up of price, which includes shipping and installation (FCInv) and investment in net working capital (NWCInv).

outlay = FCInv + NWCInv

The change in NWCInc must be accounted for as new operations/projects/services usually require additional inventories which leads to increased accounts receivables.

NWCInv = Δnon-cash current assets − Δnon-debt current liabilities = ΔNWC

After-tax operating cash flows (CF) are the incremental cash inflows over the capital asset’s economic life. Operating cash flows are defined as:

CF = (S − C − D)(1 − T) + D

= (S − C)(1 − T) + (TD)


S = sales

C = cash operating costs

D = depreciation expense

T = marginal tax rate

Terminal year after-tax non-operating cash flows (TNOCF). At the end of the asset’s life, there are certain cash inflows that occur. These are the after-tax salvage value and the return of the net working capital.

TNOCF = SalT + NWCInv − T (SalT − BT)


SalT = pre-tax cash proceeds from sale of fixed capital

BT = book value of the fixed capital sold

Replacement Project Analysis

Replacement project analysis occurs when a firm must decide whether to replace an existing asset with a newer or better asset. There are two key differences in the analysis of a replacement project versus an expansion project. In a replacement project analysis we have to:

  1. Reflect the sale of the old asset in the calculation of the initial outlay:

outlay = FCInv + NWCInv − Sal0 + T (Sal0 − B0)

  1. Calculate the incremental operating cash flows as the cash flows from the new asset minus the cash flows from the old asset:

ΔCF = (ΔS − ΔC)(1 − T) + ΔDT

  1. Compute the terminal year non-operating cash flow:

TNOCF = (SalTNew − SalTOld) + NWCInv − T[(SalTNew − BTNew) − (SalTOld − BTOld)]

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