Incremental Cash FlowDefined along with Formula & How to Calculate
Incremental cash flow is the cash flow a company receives from accepting a new project.
Businesses use incremental cash flow analysis to look at the changes that would occur in cash inflows and outflows as the result of a capital decision or new project.
If the analysis indicates that the incremental cash flow would be positive, the new project or capital investment will increase the business’s cash flow.
Therefore, the business should consider the project.
Explaining Incremental Cash Flow
There is a formula that can be used to determine the incremental cash flow.
The formula is as follows:
Incremental Cash Flow = Cash Inflow – Initial Cash Outflow – Expense
It is important to remember that inflow should not be the only factor considered when a decision is being made as to whether a project should be accepted.
This is why cash flow is made up of several components.
The Three Components of Incremental Cash Flow
The three components that make up incremental cash flow are the initial investment, the operating cash flows, and the terminal cash flow.
We will explain each of these.
The initial investment consists of the amount of money needed to start or set up a business or project.
For example, if a bakery wanted to start selling coffee, all of the equipment necessary to start selling coffee would be part of the initial investment.
This would include items such as a grinder, drip coffee machine, espresso machine, milk, and even the first bag of coffee.
None of the money already spent on the bakery would be included even if it will be used for the coffee part of the business because these are sunk costs.
Operating Cash Flow
The operating cash flow is the cash that is expected to be generated by the business or project.
In the case of our coffee shop example, this would be the cash made from selling the coffee after subtracting the raw materials and expenses.
This would be the coffee beans as well as expenses such as the electricity to run the coffee machines and the labor to make and serve the coffee, among others.
Terminal Cash Flow
The terminal cash flow for a project would be the net cash flow received when a project ends, and the business disposes of any assets used in the project.
For the coffee shop, this would mean any money received from selling the assets that were used for the coffee part of the bakery business after any expenses associated with the project are subtracted.
Incremental cash flow consists of the net cash flow between projects, which is the cash inflow minus the cash outflow for a certain period of time.
There are also other similar methods that could be used to assist management in making budgeting decisions, such as net present value (NPV) or internal rate of return (IRR).
The primary difference that occurs when using ICF versus NPV is that the cash flows are not discounted when calculating the incremental cash flow as they are when computing net present value.
Incremental Cash Flow Example
Company ABC wants to add a new product to their ready-made food line.
However, they need to decide whether to add a microwaveable soup or rice entrée.
The company expects the soup to generate a cash flow of $600,000 and the rice entrée to generate a cash flow of $700,000 during the operating period.
If management made its decision based solely on cash flow, it would choose the rice entrée.
However, once the initial investment and expenses are subtracted, the company found the soup would have an ICF of $400,000, and the rice entrée would have an ICF of $350,000 because there would be a higher initial investment as well as higher expenses for the rice entrée.
Therefore, if the company chooses to make the decision based on incremental cash flow, the soup would be the better choice.
Although, it is always important to consider other factors when making decisions, such as how the new project might affect the cash flow of any of the company’s other projects, to ensure that the new project does not cause a reduction in the cash flow of another project.
When this happens, it is called cannibalization.
For instance, if, in our example, the company decides to produce more soup, it is important to consider whether this would cause the cash flows for the company’s current soups to decline.
Company ABC’s Incremental Cash Flows Soup vs. Rice Entrée Chart
|Incremental Cash Flow||$400,000||$350,000|
Incremental Cash Flow Advantages
Performing incremental cash flow analysis can help the management of a company decide whether or not to invest in a project.
The analysis could also help the managers in a company determine the best project when there are several from which to choose.
There are other methods that these managers could use, such as net present value or internal rate of return.
However, computing incremental cash flow is generally easier than NPV or IRR due to the fact it does not discount the cash flows.
Although, like NPV, ICF is computed early on in the decision process while capital budgeting techniques are being used.
Limits of Incremental Cash Flow
There are a number of issues that can make it difficult to prepare an incremental cash flow analysis or limit its usefulness, which are:
- Depends on Inputs: One problem with incremental cash flows is that they aren’t easy to forecast. They depend on the inputs being used for the estimates. It is hard to predict how factors such as the economy, government regulations, or other external factors may affect incremental cash flows. These factors could end up having a significant effect on cash flows.
- Sunk Costs: Incremental cash flow analysis considers the future when predicting cash flows, so it does not take into account sunk costs since these costs have already been incurred.
- Hard to Predict Cannibalization: It is hard to predict the cannibalization effect or even whether there will be a cannibalization effect. Cannibalization is the reduction in cash flow a new project can cause for another project.
- Difficult to Allocate Costs: If the company has a number of projects, it can be hard to allocate costs.
- Opportunity Costs: This analysis also fails to take opportunity costs into account. This does limit its usefulness since the money from the project being considered could be used for other purposes.
As an example, suppose that a large restaurant located outside a large amusement park decided to purchase another restaurant after finding the forecasted cash flows would exceed the initial investment and expenses from the acquisition.
So, the large restaurant acquired the other restaurant.
However, due to a slumping economy, visits to the amusement park dropped significantly, which decreased restaurant visits and caused the large restaurant to shut down its new addition.
It is never easy to predict cash flows, so there is always a risk that forecasted cash flows could be inaccurate and that the new project will fail.
So, it is always important to use other capital budgeting techniques as well when making decisions about whether or not to pursue a new project.
Other Capital Budgeting Techniques
There are a number of capital budgeting techniques that can be used to determine if a project would be a good investment.
Here are some of them.
- Accounting Rate of Return: The accounting rate of return is a method for computing the percentage of return a company will obtain from a project or investment. However, like incremental cash flow, it does not consider the time value of money.
- Net Present Value: To use the net present value technique, a company calculates the net present value of the forecasted cash inflows and cash outflows of a project for a certain period of time. The company needs to subtract the cash outflows for the project from the cash inflows. If the result is positive, the project should be considered. This is a good technique to use along with incremental cash flow analysis.
- Internal Rate of Rate: This is a type of discount rate. With this technique, the net present value of the forecasted cash flows for the project is discounted to zero. The discount rate where the net present value is zero is then compared to the company’s cost of capital. The internal rate of return does not consider external factors such as cost of capital or inflation, among others.
- Profitability Index: This ratio compares the present value of a project or investment’s incremental cash flow and the investment amount. A high profitability index is preferable.
- Incremental cash flow refers to the possible changes that would result if a company pursues a new capital investment or project.
- If an incremental cash flow analysis shows a positive cash flow, it indicates that the investment’s revenue would be greater than its expenses.
- An incremental cash flow analysis can help management determine whether or not a project or investment is worth pursuing.
Incremental cash flow analysis is a good way for a company to determine whether it should pursue a project when it is used with capital budgeting techniques such as net present value.
Incremental cash flow does have its limits, but it is good for determining if a project will be profitable as well as comparing projects to see which will be more profitable.
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