Incremental Cash Flow Analysis

The most important and also the most difficult part of an investment analysis is to calculate the cash flow associated with the project; the cost of funding the project; the cash inflow during the life of the project; and the terminal, or ending value of the project. Shareholders are interested in how many additional rupees they will receive in future for the rupees they lay out today. Hence, what matters is not the project’s total cash flow per period, but the incremental cash flow for a variety of reasons. They include;

  • Cannibalization: When a new product is introduced it may take away the sales of existing products. Cannibalization also occurs when a firm builds a plant overseas and winds up substituting foreign production for parent company exports. In this case company may lose exports because it is supplying from its overseas production center. To the extent that sales of a new product or plant just replace other corporate sales, the new project’s estimated profits must be reduced by the earnings on the lost sales. However, it is difficult to assess the true magnitude of cannibalization because of the need to determine what would have happened to sales in the absence of the new product or plant. The incremental effect of cannibalization – which is the relevant measure for capital budgeting purposes – equals the lost profit on lost sales that would not otherwise have been lost had the new project not been undertaken. Those sales that would have been lost anyway should not be counted a casualty of cannibalization.
  • Sales Creation: This is opposite of the cannibalization. For some firms, when they set up manufacturing facilities abroad their overall image may goes up and sales in the domestic market may increase. At the same time their local units may supply components to their foreign units and achieve synergy. In calculating the project’s cash flows, the additional sales and associated incremental cash flows should be attributed to the project.
  • Opportunity Cost: Project costs must include the true economic cost of any resource required for the project, regardless of whether the firm already owns the resource or has to go out and acquire it. This true cost is the opportunity cost, the cash the asset could generate for the firm should it be sold or put to some other productive use. Suppose a firm decides to builds a new plant on some land it bought ten years ago, it must include the cost of the land in calculating the value of undertaking the project. Also, this cost must be based on the current market value of the land, not the price it paid ten years ago. Read More: Opportunity Cost Principle
  • Transfer Pricing: Transfer prices at which goods and services are traded internally can significantly distort the profitability of a proposed investment. Where possible, the prices used to evaluate project inputs or outputs should be market prices. If no market exists for the product, then the firm must evaluate the project based on the cost savings or additional profits to the corporation of going ahead with the project. Read More: Transfer Pricing Methods
  • Fees and Royalties: Often companies will charge projects for various items such as legal counsel, power, lighting, heat, rent, research and development, headquarters staff, management costs, and the like. These charges appear in the form of fees and royalties. They are costs to the project, but are a benefit from the standpoint of the parent firm. From an economic standpoint, the project should be charged only for the additional expenditures that are attributable to the project; those overhead expenses that are unaffected by the project should not be included when estimating project cash flows.

In general, incremental cash flows associated with an investment can be found only by subtracting worldwide corporate cash flows without the investment from post investment corporate cash flows.

In performing this incremental cash flow analysis, the key question that managers must ask is, What will happen if we don’t make this investment?

Failure to heed this question led General Motors to lose business to Japanese automakers in small car segment. Small cars looked less profitable to GM’s current mix of cars. Eventually Japanese firms were able to expand and threaten GM’s base business. Many companies that thought overseas expansion too risky today find their worldwide competitive positions eroding. They didn’t adequately consider the consequences of not building a strong global position. Global investments thus must be considered on their strategic importance and not merely on the basis of risk return analysis in short term.

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