Custom Search

Calculating Cash Flow

A project cash flow is the sum of three components: investment in fixed assets such as plant and equipment, investment in working capital, and cash flow from operations:

Total cash flow = cash flow from investment in plant and equipment + cash flow from investments in working capital + cash flow from operations

Let s examine each of these in turn.

CAPITAL INVESTMENT

To get a project off the ground, a company will typically need to make considerable upfront investments in plant, equipment, research, marketing, and so on. For example, Gillette spent about $750 million to develop and build the production line for its Mach3 razor cartridge and an additional $300 million in its initial marketing campaign, largely before a single razor was sold. These expenditures are negative cash flows negative

because they represent a cash outflow from the firm. Conversely, if a piece of machinery can be sold when the project winds down, the sales price (net of any taxes on the sale) represents a positive cash flow to the firm.

Cash Flow from Investments

Gillette s competitor, Slick, invests $800 million to develop the Mock4 razor blade. The specialized blade factory will run for 7 years, until it is replaced by a more advanced technology. At that point, the machinery will be sold for scrap metal, for a price of $50 million. Taxes of $10 million will be assessed on the sale.

Therefore, the initial cash flow from investment is $800 million, and the cash flow in 7 years from the disinvestment in the production line will be $50 million $10 million = $40 million.

INVESTMENT IN WORKING CAPITAL

We pointed out earlier that when a company builds up inventories of raw materials or finished product, the company s cash is reduced; the reduction in cash reflects the firm s investment in inventories. Similarly, cash is reduced when customers are slow to pay their bills in this case, the firm makes an investment in accounts receivable. Investment in working capital, just like investment in plant and equipment, represents a negative cash flow. On the other hand, later in the life of a project, when inventories are sold off and accounts receivable are collected, the firm s investment in working capital is reduced as it converts these assets into cash.

Cash Flow from Investments in Working Capital

Slick makes an initial (Year 0) investment of $10 million in inventories of plastic and steel for its blade plant. Then in Year 1 it accumulates an additional $20 million of raw materials. The total level of inventories is now $10 million + $20 million = $30 million, but the cash expenditure in Year 1 is simply the $20 million addition to inventory. The $20 million investment in additional inventory results in a cash flow of $20 million. Later on, say in Year 5, the company begins planning for the next-generation blade. At this point, it decides to reduce its inventory of raw material from $20 million to $15 million. This reduction in inventory investment frees up $5 million of cash, which is a positive cash flow. Therefore, the cash flows from inventory investment are $10 million in Year 0, $20 million in Year 1, and +$5 million in Year 5. In general,

An increase in working capital implies a negative cash flow; a decrease implies a positive cash flow. The cash flow is measured by the change in working capital, not the level of working capital.