9/29/2023

INITIAL INVESTMENT / OUTLAY INITIAL INVESTMENT / OUTLAY

Definitions
Definition • Fixed Capital Investment – refers to the investment made in order to purchase new equipment required
• An initial outlay refers to the initial investments needed in order to begin a given project. For instance, for the project. This cost also encompasses installation and shipping costs involved with purchasing
if opening a new factory, a company would need to purchase new land, machinery and inventory in equipment. This is often considered to be a long-term investment.
order to get the project going • Working Capital Investment – refers to the investment made at the beginning of the project to cover the
initial operating expenses of the project (for example, raw materials inventory). This part of the initial outlay
Formula is often considered to be a short-term investment.
Initial Outlay = • Salvage Value – refers to the cash proceeds collected from the sale of old equipment or assets. Such
Fixed Capital Investment (incl. installation costs) proceeds are only realized if a company actually decides to sell off older assets. For example, if the project
Plus: Changes in Net Working Capital was an overhaul of a production facility, this might involve selling off old equipment. The term only applies
• Inventory (increase +, decrease -) in cases where there the company is selling off older fixed assets in connection with beginning the new
• Accounts receivable (increase +, decrease -) Assets project. The salvage value is often quite close to the prevailing market value for the particular asset.
• Other assets (increase +, decrease -) • Book Value – refers to the net book value of the old assets. The book value refers to how much a given
• Accounts payable (increase -, decrease +) asset is worth on the company’s accounting records. It is different from the salvage value, as it does not
Less: Salvage Value of Old Asset represent a cash inflow or outflow. It is only used to calculate any gains or losses from the sale of old
Plus: Tax on Sale of Old Asset (Profit from Sale of Old Asset * Tax Rate) assets.

INITIAL INVESTMENT / OUTLAY INITIAL INVESTMENT / OUTLAY: EXAMPLE

Definitions
• Tax Rate – refers to the effective tax rate in the jurisdiction where the company is reporting its earnings.
• (Salvage Value – Book Value) x (Tax Rate) – refers to the tax on gains or losses realized on the sale of older
equipment. For instance, if an old piece of machinery is sold for more than its book value, the company will
realize a capital gain and be charged taxes on this gain. Conversely, if the piece of machinery is sold for less
than its book value, the company will experience a loss but also a tax benefit.
Given
Jane’s Kitchen sells fresh baked cookies on a busy street. Jane currently uses a single oven, which cannot
keep up with the store’s demand. Jane is considering buying a new, better oven that will produce enough
cookies to meet the demand.
She also decides to sell off her old oven since it will no longer be needed. The existing oven is currently
worth $1,000. Jane negotiates a deal with a smaller bakery to sell them her old oven for its market price
of $1,500. The new oven will cost Jane $5,000. In anticipation of increased production, Jane decides to
stock up on ingredients and buys $800 worth of flour. Her business’ tax rate is 35%.

What is her initial outlay?

Fixed Capital Investment $5,000

Plus: Working Capital Investment 800
Less: Salvage Value (1,500)
Plus: Tax on Gain on Sale (1,500 - 1,000) * 35% 175
Initial Outlay $4,475
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FINAL YEAR CASHFLOW TERMINAL CASH FLOW

Definition
• Final Year CF is Final year project operating cashflow + Terminal Cash Flow
• Terminal cash flow is the final cash flow (i.e., Net of cash inflow & cash outflow) at the end of the
project and includes after-tax cash flow from disposing of all the equipment related to the project and
recoupment of working capital
Definition
• Terminal cash flow is the final cash flow (i.e., Net of cash inflow & cash outflow) at the end of the
project and includes after-tax cash flow from disposing of all the equipment related to the project and
recoupment of working capital

Formula
Final Year CF =
Final year project operating cash flow
Plus: Disposition of Working Capital
• Inventory (decrease +)
• Accounts receivable (decrease +)
• Other assets (decrease +)
• Accounts payable (decrease -)
Add: Salvage Value of Asset
Less: Tax on Sale of Asset (Profit from Sale of Asset * Tax Rate)
Formula
Terminal CF =
Disposition of Working Capital
• Inventory (decrease +)
• Accounts receivable (decrease +) Assets
Assets • Other assets (decrease +)
• Accounts payable (decrease -)
Add: Salvage Value of Asset
Less: Tax on Sale of Asset (Profit from Sale of Asset * Tax Rate)

TERMINAL CASH FLOW: AN EXAMPLE EQUIVALENT ANNUAL ANNUITY (EAA)

Given
Definition
Redtech, a manufacturing company, is considering a new project to manufacture a recyclable product that
• The equivalent annual annuity approach is one of two methods used in capital budgeting to compare
is made of paper. To begin with this manufacturing process, Redtech has to install a new machine, which
mutually exclusive projects with unequal lives.
is expected to have 5 years of economic life after that, this machine should become obsolete & replaced
• When used to compare projects with unequal lives, an investor should choose the one with the higher
by a newer technology machine. The initial investment required for this machine is $100,000.
equivalent annual annuity.

The machine is to be depreciated on a straight-line method basis over the life of the machine with Formula Financial Calculator
excepted salvage value at the end of the project is $10,000. The tax rate applicable to gain/loss on
disposal of the asset is 30%. Working capital recoupment is $ 15,000. Redtech management forecast that • Enter N, I/YR, PV, FV=0
at the end of the project, this machine can be disposed of for $25,000. Calculate the terminal cash flow?
• Solve for PMT
Actual Proceeds Received on Disposal $25,000
Less: Tax on Disposal ($25,000 – $10,000) * 30% (4,500)
After Tax Proceeds on Disposal of Machine 20,500
Any Change in Working Capital 15,000
Terminal Cash Flow $35,500 Where:
r – Project discount rate (WACC)
NPV – Net present value of project cash flows
n – project life (in years)
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EQUIVALENT ANNUAL ANNUITY (EAA): EXAMPLE STANDARD DEVIATION

Definition
Given • Project A’s expected return is P100 million with a standard deviation of P10 million
Sally’s Doughnut Shop is considering purchasing one of two machines. Machine A is a dough mixing • Project B’s expected return is P80 million with a standard deviation of P6 million
machine that has a useful life of 6 years. During this time, the machine will enable Sally to realize
significant cost savings and represents an NPV of $4 million. Machine B is an icing machine that has a Formula Graph
useful life of 4 years. During this time, the machine will allow Sally to reduce icing waste and represents 1. What is the probability that Project A’s return is
an NPV of $3 million. Sally’s doughnuts has a cost of capital of 10%. Which machine should Sally invest between P80 million to P120 million?
in? 2. What is the range of possible return values for
Using the Equivalent Annual Annuity method: Project B to 99% confident?
Formula 3. Which project is better?

1σ = 68.2% 2σ = 95.8% 3σ = 99.8%

Where:
r – Project discount rate (WACC)
NPV – Net present value of project cash flows
n – project life (in years)

STANDARD DEVIATION
Definition
• Project A’s expected return is P100 million with a standard deviation of P10 million
• Project B’s expected return is P80 million with a standard deviation of P6 million

Formula Graph
1. What is the probability that Project A’s return is
between P80 million to P120 million?
2. What is the range of possible return values for
Project B to 99% confident?
3. Which project is better?

Answers
1. 80 and 120 are two standard deviations away
from the mean so probability is 95%
2. 99% is 3 standard deviations away, therefore 80
million +/- (3 x 6 million) = P62 million to P98 1σ = 68.2% 2σ = 95.8% 3σ = 99.8%
million
3. Project A = 10/100 = 0.1
Project B = 6/80 = 0.075
Project B is better!