A typical investment will have three components of cash flows:
• Initial investment
• Annual net cash flows
• Terminal cash flows.
Initial investment
Initial investment is the net cash outlay in the period in which as asset is purchased. A major element of the initial investment is gross outplay or original value (ov) of the asset, which comprises of its cost (including accessories and spare parts) and freight and installation charges. Original value is included in the existing block of assets for computing annual depreciation.
Net cash flows
An investment is expected to generate annual cash flows from operations after the initial cash outlay has been made. Cash flows should always be estimated on an after-tax basis. Some people advocate computing of cash flows before taxes and discounting them at the before-tax discount rate to fine NPV.
Depreciation and taxes
The computation of the after-tax cash flows requires a careful treatment of non-cash expense items such as depreciation. Depreciation is an allocation of cost of asset. It involves an accounting entry and does not require any cash outflow; the cash outflow occurs when the assets are acquired.
Depreciation, calculated as per the income tax rules, is a deductible expense for computing taxes. In itself, it has no direct impact on cash flows, but it indirectly influences cash flow since it reduces the firm’s tax liability. Cash outflow for taxes saved is in fact an inflow of cash. The saving resulting from deprecation is called depreciation tax shield.