Complete Guide To Corporate Finance

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Capital Investment Decisions - Incremental Cash Flows

Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project.

There are several components that must be identified when looking at incremental cash flows: the initial outlay, cash flows from taking on the project, terminal cost (or value) and the scale and timing of the project. A positive incremental cash flow is a good indication that an organization should spend some time and money investing in the project.

Incremental Cash Flow and Capital Budgeting
When determining incremental cash flows from a new project, several problems arise: sunk costs, opportunity costs, externalities and cannibalization.

1. Sunk Costs
These are the initial outlays required to analyze a project that cannot be recovered even if a project is accepted. As such, these costs will not affect the future cash flows of the project and should not be considered when making capital-budgeting decisions.

Suppose Newco is considering whether to make an addition to its current plant to increase production. To determine if the new addition is worthwhile, Newco hired a consulting firm for $50,000 to analyze the addition and the effect it will have on production. The $50,000 is considered a sunk cost. If the project is rejected, the $50,000 will still be paid, and if the project is accepted, the $50,000 will not affect the future cash flows of the addition.

2. Opportunity Cost
This is the cost of not going forward with a project or the cash outflows that will not be earned as a result of utilizing an asset for another alternative. For example, the opportunity cost of Newco's new addition considered above is the cost of the land on which the company is considering putting the new plant addition. As such, it should be included in the analysis of the project.

3. Externality
In the consideration of incremental cash flows of a new project, there may be effects on the existing operations of the company to consider, known as "externalities." For example, the addition to Newco's plant is for the purpose of producing a new product. It must be considered whether the new product may actually take away or add to sales of the existing product.

4. Cannibalization
Cannibalization is the type of externality where the new project takes sales away from the existing product.

Changes in Net Working Capital
A change in net working capital is essentially the changes in current assets minus changes in current liabilities. Within the capital-budgeting process, a project typically adds to current assets given additional inventories or potential increases in accounts receivables from new sales. The increases to current assets, however, are offset by current liabilities needed to finance the new project.

Overall, there may be a change to net working capital from the new project.

  • If the change in net working capital is positive, the change to current assets outweighs the change in the current liabilities.
  • If, however, the change in net working capital is negative, the change to current liabilities outweighs the change in current assets.
Pro Forma Financial Statements
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