Termination cash flow
Terminal cash flow is the cash flow that appears at the end of a project and shows the after-tax proceeds from sale of the project assets and reward of working capital[1].
Main definition
Terminal cash flow has two main elements[2]:
- Proceeds from sale of project implement;
- cash flows associated with resumption of working capital to the level that dominated before the start of the project.
Terminal cash flow is an important inset in the capital budgeting process. While uniform periodic net cash flows are discounted using the present value for rent formula, terminal cash flow is treated separately from other cash flows and discounted using the present value of a single sum formula[3].
Formula of the Terminal cash flow
Terminal cash flow can be calculated using the following formula[4]:
where
- TCF - Terminal cash flow;
- Pn - Proceeds from sale of new asset;
- Po - Proceeds from sale of old asset;
- Tn - Taxes on sale of new asset;
- To - Taxes on sale of old asset;
- R - Recovery of working capital.
Example
Company X wants to increase its present value of sales purchasing a new machine because the new equipment enables the company to increase its production. The cost of buying the new machine is $100000, the life of the machine is 7 years, and its scrap value after that is $20000. After the company buys the machine, the working capital requirements to maintain and operate the machine will cost the firm $10000. At the end of the lifetime of the machine, terminal cash flow value of the machine can be intent. To calculate this, the salvage value of the machine is added to the amount the business recovers in working capital by having and using the machine, so in this situation, the terminal cash flow equals $20000 + $10000 = $30000.
Advantages of Termination cash flow
Terminal cash flow has several advantages. Firstly, it allows investors to assess the overall profitability of a project before committing to it. It gives insight into how much money can be expected as a return on investment. Secondly, it helps to accurately calculate the cost of a project and its expected payback period. Thirdly, terminal cash flow helps to identify any potential risks associated with the project, such as market conditions, cost overruns, and the possibility of capital losses. Lastly, it allows investors to make informed decisions about whether or not to commit to the project.
Limitations of Termination cash flow
Terminal cash flow is a valuable tool in assessing the overall financial return of a project, however, it is not without its limitations. Below are some of the main limitations associated with terminal cash flow:
- Termination cash flow does not take into account the time value of money. It only looks at the amount of cash at the end of the project and does not consider the amount of cash that could be generated if the funds were invested elsewhere over the same period of time.
- Termination cash flow does not consider the effects of inflation. Inflation can reduce the purchasing power of the cash, resulting in a lower return than anticipated.
- Terminal cash flow does not account for the risk associated with the project. The higher the risk, the higher the returns that need to be generated to compensate for the risk.
- Terminal cash flow does not consider the opportunity costs associated with the project. The opportunity cost is the potential return that could have been earned if the resources used in the project were instead invested elsewhere.
- Terminal cash flow does not consider any externalities, such as the environmental impact of the project.
- Terminal cash flow does not consider the non-monetary benefits associated with the project, such as improvements to the local community or social impact.
Terminal cash flow is the cash flow that appears at the end of a project and shows the after-tax proceeds from sale of the project assets and reward of working capital. Other approaches related to terminal cash flow include:
- Terminal value, which is the projected value of an asset or company at a point in the future beyond the time horizon of the traditional discounted cash flow valuation.
- Salvage value, which is the estimated resale value of an asset at the end of its useful life.
- Liquidation value, which is the estimated proceeds from the sale of a company’s assets in the event of a liquidation or bankruptcy.
- Cash flow from operations, which is the cash flow generated by the daily business operations of a company.
In summary, terminal cash flow is a measure of the cash flow that appears at the end of a project and other related approaches include terminal value, salvage value, liquidation value, and cash flow from operations.
Footnotes
| Termination cash flow — recommended articles |
| Free cash flow yield — Book profit — Combined Ratio — Degree of financial leverage — Burn Rate — Return on common equity — Economic Value Added - EVA — Ebitda ratio — Plowback Ratio |
References
- Besley S., (2008) Principles of Finance, Cengage Learning, pages 528-539
- Bhalla V.K., (2014) Financial Management, S. Chand Publishing, pages 245-253
- Dayanada D., (2002) Capital Budgeting: Financial Appraisal of Investment Projects, Cambridge University Press, pages 30-36
- DePamphilis D., (2007) Mergers, Acquisitions, and Other Restructuring Activities, Academic Press, pages 283-285
- Petty J.W., Titman S., Keown A.J., Martin P., Martin J.D., Burrow M., (2011) Financial Management: Principles and Applications, Pearson Higher Education AU, page 408
- Sharan V., (2012) International Financial Management, PHI Learning Pvt. Ltd., page 252-253
- Sharan V., (2008) International Business 2/e , Concepts, Environment And Strategy, Pearson Education India, pages 428-437
Author: Valentyna Ilyina
