Terminal Cash Flow

Terminal cash flow is the net cash flow that occurs at the end of a project and represents the after-tax proceeds from disposal of the project assets and recoupment of working capital.

Terminal cash flow is an important input in the capital budgeting process. While uniform periodic net cash flows are discounted using the present value for annuity formula, terminal cash flow is treated separately from other cash flows and discounted using the present value of a single sum formula.

Formula

Terminal cash flow has two main components:

  1. proceeds from disposal of project equipment, etc. and
  2. cash flows associated with reversion of working capital to the level that prevailed before the start of the project.

It is calculated using the following formula:

Terminal Cash Flow = After-tax Proceeds from Disposal ± Change in Working Capital

After-tax Proceeds from Disposal = Pre-tax Proceeds from Disposal − Tax on gain on Disposal

Tax on Gain on Disposal = (Pre-tax Proceeds from Disposal − Ending Book Value) × Tax Rate

Example

Safe Energy is appraising a new solar energy project. They expect the installed equipment to have an economic life of 5 years after which it is to be replaced by newer technology. The initial investment on the project amounts to $200 million, $20 million of which is on account of increased working capital. For tax purposes, the equipment is to be depreciated on a straight line basis over 5 years with expected residual value of $20 million. The company's financial analyst projects that the machinery can be disposed of for $40 million. Working capital will revert back to its initial level at the end of 5 years. Applicable interest rate on gain on disposal is 20%. Calculate the terminal cash flow.

Solution

Tax on Disposal
= (Proceeds − Book Value) × Tax Rate
= ($40 million − $20 million) × 20%
= $4 million

After Tax Proceeds from Disposal
= $40 million − $4 million
= $36 million

Terminal Cash Flow
= After-tax Proceeds from Disposal + Working Capital Recouped
= $36 million + $20 million
= $56 million

Written by Obaidullah Jan