Incremental Cash Flow

What is Incremental Cash Flow?

Incremental cash flow is the cash flow realized after a new project is accepted or a capital decision is taken. In other words, it is basically the resulting increase in cash flow from operations due to the acceptance of new capital investment or a project.

The new project can be anything from introducing a new product to opening a factory. If the project or investment results in positive incremental cash flow, then the company should invest in that project as it would increase the company’s existing cash flow.

But what if one project is to be chosen and multiple projects have positive incremental cash flows? Simple, the project with the highest cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more should be selected. But ICF shouldn’t be the only criteria for choosing a project.

Incremental Cash Flow Formula

Incremental Cash Flow = Cash Inflow – Initial Cash Outflow – Expense
Incremental-Cash-Flow

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For eg:
Source: Incremental Cash Flow (wallstreetmojo.com)

Components

When considering a project or analyzing it through cash flows of that project, one must have a holistic approach rather than looking at only inflow from that project. Incremental cash flow thus has three components to it –

Components of Incremental Cash Flow

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#1 – 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 (remember, initial investment does not include sunk costSunk CostSunk costs are all costs incurred by the firm in the past with no hope of recovery in the future and are not considered while making any decisions since these costs will not change regardless of the decision's outcome.read more)

#2 – 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 labor wages, selling and advertising, rent, repair, electricity, etc. is the operating cash flowOperating Cash FlowCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more.

#3 – 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 flowTerminal Cash FlowTerminal Cash Flow is the final cash flow (net of cash inflow and cash outflow) at the end of a project after deducting all taxes, disposing of assets, recouping working capital, and paying all other expenses.read more.

  • 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.

Examples

  • A US-based FMCG company XYZ Ltd. is looking to develop a new product.  The company has to make a decision between soap and shampoo. Soap is expected to have a cash flow of $200000 and the shampoo of $300000 during the period. Looking only at the cash flow, one would go for shampoo.
  • But after subtracting expense and initial cost, soap will have an incremental cash flow of $105000 and shampoo of $100000 as it has a greater expense and initial cost than soap. So going only by the incremental cash flows, the company would undertake the development and production of soap.
  • One should also consider the negative effects of undertaking a project as accepting a new project may result in a reduction in the cash flow of other projects. This effect is known as Cannibalization. Like in our above example, if the company goes for the production of soap, then it should also consider the fall in cash flows of existing soap products.

XYZ Ltd

ParticularSoapShampoo
Cash Flow$200,000$300,000
Less: Expense$60,000$135,000
Less: Initial Cash outflow$35,000$65,000
Incremental Cash Flow (ICF)$105,000$100,000

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 valueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more (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 techniquesCapital Budgeting TechniquesCapital Budgeting refers to a Company’s procedure for analyzing investment or project-related decisions by considering the investment to be made & expenses to be incurred. Its techniques include Net Present Value, Internal Rate of Return, Accounting Rate of Return, Profitability Index, Discounted Cash Flows, & Payback Period, etc. read more 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.

Conclusion

This technique can be used as the initial tool for screening projects. But it would need other methods to corroborate its result. Despite its shortcomings, it gives an idea about the project’s viability, profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more, and its effect on the company.

This article has been a guide to What is Incremental Cash Flow and its definition. Here we discuss formula to calculate the incremental cash flow along with the example, components, advantages, and disadvantages. You can learn more about from the following articles –

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