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. should be selected. But ICF shouldn’t be the only criteria for choosing a project.
Incremental Cash Flow Formula
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 –
#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.)
#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 expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit. 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..
#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..
- So, ICF is the net cash flowNet Cash FlowNet cash flow refers to the difference in cash inflows and outflows, generated or lost over the period, from all business activities combined. In simple terms, it is the net impact of the organization's cash inflow and cash outflow for a particular period, say monthly, quarterly, annually, as may be required. (cash inflow – cash outflow) over a specific time between two or more projects.
- NPV and IRRIRRInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected. 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.
- 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.
|Less: Initial Cash outflow||$35,000||$65,000|
|Incremental Cash Flow (ICF)||$105,000||$100,000|
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. (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. like NPV.
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.
- For example – Tata steel acquired the Corus group for $12.9 billion in 2007 to tap and enter into the European market as Corus was one of the largest steelmakers in Europe that produced high-quality steel and Tata was a low quality steel producer. Tata forecasted the cash flows and benefits arising out of acquisitionAcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion. and also analyzed that the cost of acquisition was less than the setting up its plant in Europe.
- But many external and internal factors led to a slump in steel demand in Europe, and Tata’s were forced to shut down its acquired plant in Europe and are planning to sell some of its acquired business.
- So, even large companies like Tata steel couldn’t accurately predict or forecast market conditions and, as a result, suffered huge losses.
- It cannot be the sole technique for selecting a project. ICF in itself is not sufficient and needs to be validated or combined with other capital budgeting techniques that overcome its shortcomings like NPV, IRR, Payback periodPayback PeriodThe payback period refers to the time that a project or investment takes to compensate for its total initial cost. In other words, it is the duration an investment or project requires to attain the break-even point., etc. which, unlike ICF, considers the TVMTVMThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment..
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., 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 –