Initial Outlay – Meaning, Importance And Calculation

Before one starts a business, it is important to know the amount that one will be investing in it. This initial amount is the initial outlay or initial investment outlay or just initial investment. The initial outlay can be for starting a new business, or a new project in an existing company or even upgrading the existing facility.

Though it is virtually impossible to estimate all the costs of starting a business, one can easily estimate some basic costs, such as equipment, materials, labor, and insurance. These costs together constitute initial outlay.

Importance

  • Management usually takes a decision to proceed with a particular project after evaluating its profitability. For this, the company needs to take into account the initial outlay of the project along with its revenue stream.
  • If a business is seeking a loan for starting a new project, then lenders would want an estimate of initial investment along with the business plan.
  • Initial outlay is also an input for calculating NPV (net present value) and IRR (internal rate of return).

Initial Outlay – Meaning, Importance And Calculation

Formula

Initial investment equals capital expenditures or fixed capital investment (such as machinery, tools, shipment and installation, more) plus a change in working capital, minus proceed from the sale old asset, plus tax adjusted profit or loss from the sale of assets.

Thus, initial outlay = Capital expenditure + Change in working capital – sale of old asset+ Profit from sale of asset *(Tax rate)

Before moving onto the calculation, let’s understand each of these items in detail:

Capital expenditures or fixed capital investment: This includes investment in the new equipment or other fixed assets, such as land. Moreover, it also includes installation and shipping costs related to the purchase of the equipment.

Changes in working capital: a new project results in a change in working capital, such as raw materials, inventory and more. Usually, the working capital requirement increases with a new project. However, it may drop as well if a company is updating to new efficient machinery.

Proceed from the sale old asset: it refers to the amount that one gets after selling the old equipment or assets. Such proceeds are also called salvage value and are close to the current market value of the asset sold.

Ideally, such an item should be considered if the company is updating the current facility. For instance, upgrading the production facility might involve selling old machines or equipment. However, in case, of developing a completely new facility, a business may not have any old asset to dispose of.

Tax on profit or loss from the sale of assets: if a company sells the old asset for more than its book value (value in the company’s record), then there will be a capital gain. On this profit, the company will have to pay the applicable tax. On the other hand, if a company incurs a loss on the sale of the old asset, it would prove tax benefit.

How to Calculate Initial Outlay?

  1. Add all the explicit initial outlay or costs. Such items directly relate to the investment or expansion of a project. For example, the cost of equipment, its shipping cost, fees and installation costs.
  2. Next, calculate the change in the working capital due to the project. For instance, a business may have to adjust accounts receivable and payable because of undertaking the project. Also, a business may need to adjust inventory for raw material depending on the project.
  3. Now add the salvage value (if any) for the old equipment.
  4. Tax on profit from the sale of the old asset must be added back.
  5. Now add all the above heads to arrive at the initial outlay.

Let us understand the calculation with the help of a simple example. Company A is upgrading its existing production line and purchases new equipment worth $500000 and incurs $10000 as installation expenses. The company expects the working capital requirement to drop by $3000 because of this new efficient equipment. Company A sold the old equipment (whose book value was $20000) for $30000. The effective tax rate is 20%.

In this case total capital expenditure will be $510000, change in working capital is -$3000, and tax on profit on the sale of old asset is ($30000-$20000)*20% = $2000

Initial Outlay = $510000 – $3000 – $3000 + $2000 = $530000.

One can use this initial outlay for calculating the NPV (net present value) or even the IRR (internal rate of return for a project). Calculating these two will give management a better view of whether or not to undertake the project.

Last updated on : September 24th, 2019
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