Cash Flow Projection
When increasing sales levels or investing in a new project, there are key areas to address in the cash flow assumptions.
First the cash flow projections include depreciation. IRS accelerated depreciation allows for quicker write-off of assets, lowering taxable income and reducing tax expense. So, high depreciation expense in the early years will increase project cash flows in these years through the depreciation tax shield. Note: the depreciable base includes asset cost, installation and shipping.
The depreciation schedule for an asset does not correspond with the physical life of a project, and the economic life of the project is tied to the project life- which is dependent on the timeframe which maximizes firm value. So projects in mining, for example, may terminate the project at which point operations no longer enhance firm value. The asset will then be sold for market value resulting in a cash inflow for the project at project end.
Second, the cash flow projections integrate income and capital gain taxation. The discount rate will reflect the after-tax cost of capital, which includes the tax shield on firm interest expense. If an asset has salvage value at the end of the project, the price received will be reduced by taxable gain.
Third, the change in operating working capital is part of the initial investment at the start of the project. And when the project terminates, this investment in working capital is returned as a cash inflow. As sales increase, firms will naturally experience an increase in inventory and receivables, and cash needs, so this higher level of working capital and the changes in working capital levels through the life of the project are integrated into the cash flow assumptions. At project end, those capital requirements reverse and show as cash inflows.
Fourth, since we are calculating cash flows before