Incremental cash flow principle for evaluation of replacement decisions
- The investment at the beginning is net of the salvage value of the existing machine
- While considering depreciation, only the differential should be taken into account, i.e., the difference between depreciation on the new machine and depreciation on the existing machine for the remainder of its economic life at least (the remainder of economic life of the existing machine is bound to be shorter than for a new machine)
- There could be additional investment by way of incremental working capital at the beginning besides capital cost.
- The salvage value of the existing machine at the end also should be taken as cash inflow along with the withdrawal of additional working capital as at point no. 3
- The incremental value in the cash flow could be due to increase in revenues (very little chances for this) or due to reduction in cost (this is more likely to happen – replacing increasing the operating efficiency)
- Construct the cash flows and on net cash inflow apply the chosen discounting rate
- Cash flow = Net inflow after tax + differential depreciation added back
- In case the cash inflow is negative, do not calculate tax on that and carry forward the loss to the next year and deduct the same from the next year’s net cash inflow before paying taxes.