(185)---COMPONENT OF CASH FLOWS

Component of Cash Flows

Terminal cash flows

The last or terminal year of an investment may have additional cash flows.

• Salvage value

Salvage value (SV) is the most common example of terminal cash flows. Salvage value may be defined as the market price of an investment at the time of its sale. The cash proceeds net of taxes from the sale of the assets will be treated as cash inflow in the terminal (last) year. As per the existing tax laws, no immediate tax liability (or tax savings) will arise on the sale of an asset because the value of the asset sold is adjusted in the depreciable base assets.

In the case of a replacement decisions, in addition to the salvage value of the new investment at the end of its life, two other salvage values have to be considered:

1. The salvage value of the existing asset now (at the time of replacement decision)
2. The salvage value of the existing asset at the end of its life, if it were not replaced.

If the existing asset is replaced, its salvage value not will increase the current cash inflow, or will decrease the initial cash outlay of the net assets. However, the firm will have to forgo its end-of-life salvage value. This means reduced cash inflow in the last year of the new investment.

The effects of the salvage values of existing and new assets may be summarized as flows:

• Salvage value of the new asset. It will increase cash inflow in the terminal (last) period of the new investment.
• Salvage value of the existing asset now. It will reduce the initial cash outlay of the new asset.
• Salvage value of the existing asset at the end of its nominal life. It will reduce the cash flow of the new investment of in the period in which the existing asset is sold.

Sometimes removal costs may have to be incurred to replace an existing asset. Salvage value should be computed after adjusting these costs.