Two types of capital projects that a firm may consider are:

**Expansion Projects:**these are projects where the firm seeks to profitably increase sales of current products or introduce new products into the market.**Replacement Projects:**these are projects where the firm must either: replace worn out equipment or invest in new equipment that is expected to lower current production costs and/or increase current sales.

## Calculating Cash Flows for Expansion Projects

OCF = EBIT(1 – tax rate) + Deprecation

Notes on OCF:

- OCF must only be calculated based on incremental values that are a direct result of the capital project.
- Sunk costs are always excluded from the calculation.
- Depreciation is added back after taxes because this is a non-cash charge.
- Interest expense is not included because that cost will be captured in the discount rate applied when calculating the present value of future cash flows.

TNOCF = Sale of Fixed Capital + Working Capital Investment Recovery – ((Sale of Fixed Capital – Book Value of Fixed Capital) * (tax rate))

**Notes on TNOCF:** the sale of fixed capital might be at a gain or loss, depending on whether or not the fixed capital is sold above or below book value.

Calculate a net present value (NPV) for the project to determine if it should be undertaken by the firm.

- The NPV calculation typically applies the firm’s marginal weighted average cost of capital (WACC) as the discount rate.
- A project with a negative NPV should be rejected by the firm.

## Calculating Cash Flows for Replacement Projects

Initial Investment = Fixed Capital Investment + Working Capital Investment – Sale of Old Equipment + ((Sale of Old Equip – Book Value of Old Equip)(tax rate))

**Notes on initial investment for a replacement project:** replacement projects commonly include the sale of old equipment, so there is an additional consideration in the calculation that is not included in the analysis of an expansion project.

- The calculation is the same for a replacement project as it is an expansion project (EBIT (1-tax rate) + Depreciation), but there are two considerations that the analyst must make:
- First, will the project increase sales?
- Second, by how much is the replacement project reducing annual operating expenses?
- Each of these questions must be considered when calculating OCFs for a replacement project. It could be that the replacement project does not increase sales at all, but is being considered solely on its potential to reduce operating costs.

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