King Faisal University [ ] 1 Business School Management Department Finance Pre-MBA Dr Abdeldjelil Ferhat BOUDAH 1

King Faisal University [ ] CHAPTER 10 CASH FLOWS COMPONENTS 2 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS INTRODUCTION I- MAJOR CASH FLOW COMPONENTS II- EXPANSION VERSUS REPLACEMENT CASH FLOWS III- SUNK COSTS AND OPPORTUNITY COSTS CONCLUSION 3 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS INTRODUCTION To evaluate capital expenditure alternatives, the relevant cash flows, which are the incremental after- tax cash outflow (investment) and resulting subsequent inflows, must be determined. 4 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10 : CASH FLOWS PRINCIPLES CHAPTER 10 : CASH FLOWS PRINCIPLES The incremental cash flows represent the additional cash flows-outflows or inflows-expected to result from a proposed capital expenditure. As noted in chapter 3, cash flows, rather than accounting figures, are used because it is these flows that directly affect the firm ability to pay bills and purchase assets. 5 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS I- MAJOR CASH FLOW COMPONENTS The cash flows of any project having the conventional pattern can include three basic components: 1- An initial investment 2- Operating cash inflows 3- Terminal cash flow I- MAJOR CASH FLOW COMPONENTS The cash flows of any project having the conventional pattern can include three basic components: 1- An initial investment 2- Operating cash inflows 3- Terminal cash flow 6 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS All projects- whether for expansion, replacement, renewal, or other some purposes- have the first two components. Figure 8.3 depicts the cash flows for a project on time line. Each of the cash flow components is labeled. 7 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS Initial investment: is the relevant cash outflow for a proposed project at time zero. Operating cash inflows: are the incremental after-tax cash inflows resulting from use of a project during its life. Terminal cash flow: is the after-tax non operating cash flow occurring in the final year of a project, usually attributable to liquidation of the project. 8 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS II- EXPANSION VERSUS REPLACEMENT CASH FLOWS The development of relevant cash flows is most straightforward in the case of expansion decisions. In this case, the initial investment, operating cash inflows, and terminal cash flow are merely the after-tax cash outflow and inflow associated with the proposed outlay. II- EXPANSION VERSUS REPLACEMENT CASH FLOWS The development of relevant cash flows is most straightforward in the case of expansion decisions. In this case, the initial investment, operating cash inflows, and terminal cash flow are merely the after-tax cash outflow and inflow associated with the proposed outlay. 9 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS II- EXPANSION VERSUS REPLACEMENT CASH FLOWS The development of relevant cash flows for replacement decisions is more complicated; the firm must find the incremental cash outflows and inflows that will result from the proposed replacement. 10 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS II- EXPANSION VERSUS REPLACEMENT CASH FLOWS The initial investment in this case is found by subtracting from the initial investment needed to acquire the new asset any after-tax cash inflows expected from liquidation today of the old asset being replaced. 11 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS 12 Dr Abdeldjelil Ferhat BOUDAH Expansion and Replacement cash flows Replacementexpansion Relevant cash flows [(4)= (2)- (3)] Old Asset A (3) New Asset A (2) New Asset A (1) Initial investment

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS 13 Dr Abdeldjelil Ferhat BOUDAH $10000………$10000$13000 Initial Invest Operating cash inflowsYear $2000$3000$

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS 14 Dr Abdeldjelil Ferhat BOUDAH $10000………$10000$13000 Initial Invest Operating cash inflowsYear $3500$1500$ Terminal Cash Flow

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS III- SUNK COSTS AND OPPORTUNITY COSTS Sunk costs: Cash outflows that have already been made (that is past outlays) and therefore have no effect on the cash flows relevant to a current decision. As a result, sunk costs should not be included in project’s incremental cash flows III- SUNK COSTS AND OPPORTUNITY COSTS Sunk costs: Cash outflows that have already been made (that is past outlays) and therefore have no effect on the cash flows relevant to a current decision. As a result, sunk costs should not be included in project’s incremental cash flows 15 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS Opportunity costs: Cash flows that could be realized from the best alternative use of an owned asset that will be used in a proposed project. Therefore, they represent cash flows that will not be realized as a result of employing the given asset in the proposed project 16 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 10: CASH FLOWS COMPONENTS CHAPTER 10: CASH FLOWS COMPONENTS CONCLUSION From capital budgeting point of view, cash flows must be based on the incremental cash flows in order to make the right decision. Further, the investment within an organization as we have seen might be as a subject for different kinds of alternatives. Therefore, it would be so valuable if the decision making for investment is clarified in terms incremental cash flows. 17 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] 18 بحمد الله