Annual net cash flows will continue to be received till the last or terminal year. In this year, the value received as salvage value along with incremental net cash flow for the last or terminal year will amounts to the terminal cash flow. Therefore, terminal cash flow is the cash flow received during the last or terminal year of investment.
Salvage value
Salvage value may be defined as the market price of an investment at the time of its sale. The cash proceeds from the sale of the assets will be treated as cash inflow in the terminal (last) year. As per the existing tax laws in India, no tax liability will arise on the sale of an asset. The value of the asset sold is adjusted in the depreciable base of assets. In case of a replacement decision, in addition to the salvage value of the new investment at the end of its life, two other salvage values have to be considered. They are
- The salvage value of the existing assets now (at the time of replacement decision)
- The salvage value of the existing assets at the end of its life, if it were not replaced.
Terminal cash flow has two main components:
- proceeds from disposal of project equipment, etc. and
- 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
