Expansion Projects vs. Replacement Projects and Cash Flows

This lesson is part 3 of 20 in the course Corporate Finance Part 1

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

Initial Investment = Fixed Capital Investment + Working Capital Investment

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.