Definition:
An incremental cash flow arises when the company opts to execute some new project. Suppose the project is expected to produce net positive cash inflow; the project is deemed to be financially viable. A positive steady income implies that the organization’s income will increase with acceptance of the venture and vice versa.
From a financial perspective, incremental cash flow can be an excellent tool to assess the project’s economic feasibility.
For instance, a well-known technique to appraise incremental cash flow is NPV analysis that uses cumulative cash flow as a basis of evaluation. However, other effects of the project need to be considered before making any final decision for opting for the new project.
Incremental cash flow and costing
There is a strong connection between incremental cash flow and relevant costing. To forecast the cash flow for the project, the managers must consider the concepts of the costing pertinent to reach the most suitable decision in the current situation.
The frequently used concepts of relevant costing include sunk cost, opportunity cost, and incremental cost. Let’s discuss these concepts in some detail.
Sunk cost
Suck cost is the cost that the business can not recover. It’s a past commitment and does not affect the future. That’s why it’s not considered while calculating incremental cash flows.
Opportunity cost
An opportunity cost is a cost of preceding some benefits that could be obtained by not choosing for the project. For instance, If the business accepts a new project and has to internally use the land rented to tenants for USD 12,000 per month, losing USD12,000 per month is an opportunity cost that needs to be taken in the calculations incremental cash flow.
Incremental cost
An incremental cost arises due to the activities of the newly accepted project. It’s highly a highly relevant cost and directly attributable to the activities of the project. For instance, some specialized machine needs to be purchased for the project.
To come up with incremental cash flow, all the cash flows expected from the new project (inflow/outflow) need to be considered. These cash flows include startup cash flows, regular cash flow, and the cash flows on termination of the project.
Startup cash flows include the cash outflow for the expenses incurred before the project earns revenue. For instance, the cost of setting up the plant is stat up cost. The regular cash flows include in and outflow of the cash on an operating basis.
These cash flows are expected to be part of the project and remain intact until the project is winded up—for instance, the cash inflow arising from selling products manufactured under the scheme.
The termination cash is when the project is discontinued. For instance, the business may have to incur the cost of restoring the production facility before ending the rental agreement. To come up with accurate incremental cash flows, all the expenses and income need to be analyzed with the concepts of relevant costing.
Formula
The formula of the incremental cash flow is as follows,
Incremental cash flow = Cash inflow – Initial cash flow – Expenses
Interpretation of the formula
The incremental cash flow deducts all the initial cash flows and ongoing expenses from the expected inflow of the cash. It’s based on the in/outflow of the cash. The concept of the relevant costing needs to be applied for the calculation.
Example – 1
Consider an investment opportunity that requires USD120,000 in the initial years and five years of life. The income expected is USD30,000 per annum. We can put the figures in the formula to get if the project is financially viable.
Incremental cash flow = USD (5*30,000) – (120,000)
Incremental cash flow = USD 150,000 – 120,000
Incremental cash flow = USD 30,000
The given calculations show that incremental cash flow is positive and acceptance of the project seems to be financially viable.
Example – 2
Consider an investment opportunity that requires USD160,000 in the initial years and five years of life. The income expected is USD 30,000 per annum. We can put the figures in the formula to get if the project is financially viable.
Incremental cash flow = USD (5*30,000) – (160,000)
Incremental cash flow = USD 150,000 – 160,000
Incremental cash flow = USD 10,000
The given calculation shows that incremental cash flow is negative, and the project does not seem to be financially feasible. However, other non-financial factors should also be considered before making any finical decision to reject the project.
Advantages
- Incremental cash flow provides a concise and clear basis for making a decision about the rejection or acceptance of the project.
- It uses the concepts of the relevant costing that adds massive value in the process of decision making.
- It’s based on the cash flow which is easy to use rather than the complex concepts of accrual accounting.
- The incremental cash flow helps to understand the impact on the liquidity of the company if the project is accepted. For instance, if the project is expected to generate massive cash after five years, it might alert the managers and decision-makers if they can feed the project and survive till the completion of the five years. Hence, the managers only accept the project if they have sufficient resources to survive without cash inflow for longer terms.
Limitations
- It does not compare return with the investment required. Hence, it does not have greater value when multiple investments need to be compared.
- It’s not always easy to understand the concepts of relevant costing. Especially, when there is a complex situation of the cost and income that include in and outflow of the cash.
- Incremental cash flow is calculated based on the assumptions of the future, the assumptions may change with the change in of the situation in the future.
- The calculation of the incremental cash flow makes use of discount rate, which is often estimated as some companies use the cost of capital and some companies use interest rate in the market.
