To start capital budgeting decision-making process, we firstly need to look at the cash flows of the proposed projects. The cash flows of the project with conventional cash flow pattern may include three components: initial investment, operating cash inflows and terminal cash flow. The first two components are unavoidable and the last component is not always present.
It is also important to note that financing cost is included in the discount rate (required return) and is not included in the cash flows. Financing cost refers to cost of funds that are required for investment in the project.
Further, all cash flows are measured on incremental after-tax basis. Incremental cash flows refer to the additional (marginal) cash flows anticipated from the proposed project. In simple terms, it refers to additional cash flows that occur only if project will be undertaken. For example, if cash inflows prior to commencement of project A were $500,000 and after commencement of project A were $600,000 than incremental cash inflow is $100,000 ($600,000- 500,000). It is calculated as cash inflow with project A minus cash inflow without project A.
Overall, ones initial investment, operating cash inflows and terminal cash flow determined, we can calculate outline of the cash flows from the project as follows:
= Operating cash inflows +/- Terminal cash flow – Initial investment