What is Terminal Cash Flow?
Terminal Cash Flow is 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.
For any company who uses the capital budgetingCapital BudgetingCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds. approach to estimate the overall figure of an ongoing project or a project which company management is planning to undertake, they give the more clear understanding about earnings of the project to the company management, which help management initially to decide whether to accept or reject a project.
Let’s say an XYZ company got an offer from state authority to construct an overhead bridge. Company management accepted the offer, and they knew that to complete this project, they require special machinery. They also knew that once this project is completed or terminated, this special bridge construction machinery is not required to the company, so management decided to dispose of this machinery at the end of the project to get some of their initial investment recovered. The final amount recovered from disposing of this machinery becomes one of the important components while calculating terminal cash flow.
How to Calculate Terminal Cash Flow?
Terminal cash flow can be calculated by using the below formula:
Terminal Cash Flow Formula = After-Tax Proceeds from Disposal of Project Equipment + Any Change in Working Capital
Let discuss an example.
Redtech, a manufacturing company, is considering a new project to manufacture a recyclable product that is made of paper. To begin with this manufacturing process, Redtech has to install a new machine, which is expected to have 5 years of economic life after that, this machine should become obsolete & replaced by a newer technology machine. The initial investment required for this machine is $100,000.
The machine is to be depreciated on a straight-line method basis over the life of the machine with excepted salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000. 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 at the end of the project, this machine can be disposed of for $25,000. Calculate the terminal cash flow?
To calculate the terminal value, the following are the key component:
- Initial Investment required: $ 100,000.
- Working capital recoupment: $ 15,000.
- The tax rate on disposal: 30%.
- Salvage Value: $ 10,000.
As you saw in the question that at the end of the project, management expects cash proceeds on disposal is $25,000, which is higher than the book value of the machine at the end of the project by $15,000 ($25,000 – $10,000).
Calculation of terminal cash flow will be –
- Actual Proceeds Received on Disposal = $25,000.
- Tax on Disposal = ($25,000 – $10,000) * 30%
- Tax on Disposal =$4,500.
- After Tax Proceeds on Disposal of Machine = ($25,000 – &4,500) = $20,500.
- Any Change in Working Capital = $ 15,000.
- Terminal Cash Flow = $20,500 + $15,000 = $35,500
- Company management can decide more precisely whether to accept or reject the project.
- Including terminal cash flow gives an accurate figure to analysts while estimating the value of the project.
- Incorrect forecasting the disposable value of the asset at the end of the project.
- Sometimes actual life of the projects or equipment differs from the assumption made by management initially.
- Terminal cash flow is mostly used for the project only with a finite life.
Important Point to Remember
Terminal cash flow is the final cash flow at the end of the project. It consists of cash flow from asset disposal & working capital recoupment.
This is the last amount of cash left with the company after the project is terminated; all assets related to the project are disposed of; the working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)" is recovered. Considering this cash flow in estimating earningsEstimating EarningsEarnings Estimate is the projection of earning of an entity for a given period. Future projects, cash flows, market conditions, and several other factors are considered in calculating this estimate. give company management a more accurate figure to decide whether to accept or reject the project.
This has been a guide to what is terminal cash flow and its definition. Here we discuss the formula to calculate terminal cash flow along with an example, advantages, and disadvantages. You can learn more about finance from the following articles –