by Incremental cash flow refers to cash flow that is acquired by a company when it takes on a new project. To estimate an incremental cash flow, businesses must compare projected cash flow if it takes on a new project to when it doesn’t, putting into consideration how accepting such project may affect the cash flow of another part of the business.
Incremental Cash Flow = Cash Inflow – Initial Cash Outflow – Expense
Components
Initial Investment Outlay
It is the amount needed to set up or start a project or a business. E.g., a cement manufacturing company plans to set up a manufacturing plant at XYZ city. So all the investment from buying land and setting up a plant to manufacturing the first bag of cement will come under initial investment.
Operating Cash Flow
Operating cash flow refers to the amount of cash generated by that particular project, less operating, and raw material expense. If we consider the above example, the cash generated by selling cement bags less than the raw material and operating expenses like labour wages, selling and advertising, rent, repair, electricity, etc. is the operating cash flow.
Terminal Year Cash Flow
Terminal cash flow refers to net cash flow that occurs at the end of the project or business after disposing of all the assets of that particular project. Like in the above example, if the cement manufacturer company decides to shut down its operation and sell its plant, the resulting cash flow after brokerage and other costs is terminal cash flow.
- So, ICF is the net cash flow (cash inflow – cash outflow) over a specific time between two or more projects.
- NPV and IRR are other methods for making capital budgeting decisions. The only difference between NPV and ICF is that while calculating ICF, we do not discount the cash flows, whereas, in NPV, we discount it.
Advantages
It helps in the decision of whether to invest in a project or which project among available ones would maximize the returns. Compared to other methods like Net present value (NPV) and Internal rate of return (IRR), Incremental cash flow is easier to calculate without any complications of the discount rate. ICF is calculated in the initial steps while using capital budgeting techniques like NPV.
Limitations
Practically incremental cash flows are complicated to forecast. It is as good as the inputs to the estimates. Also, the cannibalization effect, if any, is difficult to project.
Besides endogenous factors, there are many exogenous factors that may affect a project greatly but are challenging to forecast like government policies, market conditions, legal environment, natural disaster, etc. which may impact incremental cash flows in unpredictable and unexpected ways.
Difficulties in Determining Incremental Cash Flow
Incremental cash flows are helpful, especially in determining if a company should take on a new project or not. However, accountants also encounter certain difficulties when estimating incremental cash flow. Here are some of the challenges:
- Sunk costs
Sunk costs are also known as past costs that have already been incurred. Incremental cash flow looks into future costs; accountants need to make sure that sunk costs are not included in the computation. This is especially true if the sunk cost happened before any investment decision was made.
- Opportunity costs
From the term itself, opportunity costs refer to a business’ missed chance for revenues from its assets. They are often forgotten by accountants, as they do not include opportunity costs in the computation of incremental cash flow.
One example is a company that specializes in sound system installations that skips a project that requires the use of five sets of boom boxes. Currently, the business is only putting the five extra sets of boom boxes in its storage facility, instead of taking on the project that will earn $5,000. This illustrates the opportunity cost of $5,000.
- Cannibalization
As mentioned above, cannibalization is the result of taking on a new project that reduces the cash flow of another product or line of business. For example, an owner with an existing mall that caters to classes A and B, and everything it sells is sold at a premium because it caters to luxury shoppers.
In another part of the same city, it decides to open a new mall that caters to classes B, C, and D, selling the same items as the other mall but at a significantly lower price. This will result in cannibalization because some people will no longer go to the first mall because they can get most things at the new mall for a much lower price.
- Allocated costs
These are some costs that must be allocated to a specific department or project and there may not be a rational way to do it (i.e. rent expense)..
