What is an Initial Outlay?
An initial outlay refers to the initial investments needed in order to begin a given project. For instance, if opening a new factory, a company would need to purchase new land and machinery in order to get the project going.
Usually, a company’s management will base their decision to pursue certain projects based on their profitability metrics or strategic value. Nonetheless, they should also take into account the initial investment required to pursue the selected project, as well as which sources of capital they intend to draw upon. The initial outlay is used in the calculation of NPV.
How is Initial Outlay Calculated?
The initial outlay for projects can be calculated with the following formula:
- Fixed Capital Investment – refers to the investment made in order to purchase new equipment required for the project. This cost will also encompass the installation and shipping costs involved with purchasing the equipment. This is often considered to be a long-term investment.
- Working Capital Investment – refers to the investment made at the beginning of the project to cover the operating expenses of the project (for example, raw materials inventory). This is often considered to be a short-term investment.
- Salvage Value – refers to the cash proceeds collected from the sale of old equipment or assets. Such proceeds are only realized if a company actually decides to sell off older assets. For example, if the project was an overhaul of a production facility, this might involve selling off old equipment. However, if the project is centered around expanding into a brand new production facility, there may not be a need to sell off older equipment. Thus, the term only applies in cases where there the company is selling off older fixed assets. The salvage value is often times quite close to the prevailing market value for the particular asset.
- Book Value – refers to the net book value of the old equipment. The book value refers to how much a given piece of equipment is worth on the company’s accounting records (i.e., how much it’s been depreciated). It is different from the salvage value as it does not represent a cash inflow or outflow but rather is used to calculate any gains or losses on the sale of old assets.
- Tax Rate – refers to the effective tax rate in the jurisdiction where the company is reporting its earnings.
- (Salvage Value – Book Value) x (Tax Rate) – refers to any gains or losses realized on the sale of older equipment. For instance, if an old piece of machinery is sold for more than its book value, the company will realize a capital gain and thus be charged taxes on this gain. Conversely, if the piece of machinery is sold for less than its book value, the company will experience a tax benefit.
Initial Outlay Example
Jane’s Kitchen sells fresh baked cookies on a busy street. Jane currently uses a single oven, which cannot keep up with the store’s demand. Thus, Jane is considering buying a new, better oven that will produce enough cookies to meet the demand by itself. She also decides to sell off her old oven since it would no longer be needed.
The existing oven is currently worth $1,000. Jane negotiates a deal with a smaller bakery to sell off the old oven for its market price of $1,500. The new oven will cost Jane $5,000. In anticipation of increased production, Jane decides to stock up on ingredients and buys $800 worth of flour. Her business’ tax rate is 35%. What is her initial outlay?
The first step is to identify the following numbers:
Fixed Capital Investment = $5,000
Working Capital Investment = $800
Salvage Value = $1,500
Book Value = $1,000
Tax Rate = 35%
Then, we can input the numbers into our formula:
Thus, the initial outlay is of $4,475. Given all the information, she can go on to calculate the project’s NPV and other profitability metrics. Then, she can make an informed decision about whether or not to move forward with this project.
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