Incremental Cash Flows

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. 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. 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.

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. 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.

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.

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.

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.