What is Incremental Cash Flow?
Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company’s cash flow will increase with the acceptance of the project. A positive incremental cash flow is a good indication that an organization should invest in a project.
- Incremental cash flow is the potential increase or decrease in a company’s cash flow related to the acceptance of a new project or investment in a new asset.
- Positive incremental cash flow is a good sign that the investment is more profitable to the company than the expenses it will incur.
- Incremental cash flow can be a good tool to assess whether to invest in a new project or asset, but it should not be the only resource for assessing the new venture.
Understanding Incremental Cash Flow
There are several components that must be identified when looking at incremental cash flows: the initial outlay, cash flows from taking on the project, terminal cost or value, and the scale and timing of the project. Incremental cash flow is the net cash flow from all cash inflows and outflows over a specific time and between two or more business choices.
For example, a business may project the net effects on the cash flow statement of investing in a new business line or expanding an existing business line. The project with the highest incremental cash flow may be chosen as the better investment option. Incremental cash flow projections are required for calculating a project’s net present value (NPV), internal rate of return (IRR), and payback period. Projecting incremental cash flows may also be helpful in the decision of whether to invest in certain assets that will appear on the balance sheet.
Example of Incremental Cash Flow
As a simple example, assume that a business is looking to develop a new product line and has two alternatives, Line A and Line B. Over the next year, Line A is projected to have revenues of $200,000 and expenses of $50,000. Line B is expected to have revenues of $325,000 and expenses of $190,000. Line A would require an initial cash outlay of $35,000, and Line B would require an initial cash outlay of $25,000.
To calculate each project’s net incremental cash flow for the first year, an analyst would use the following formula:
ICF= Revenues − Expenses − Initial Costwhere:
In this example, the incremental cash flows for each project would be:
LA ICF=$2,−$5,−$35,=$115,LB ICF=$325,−$19,−$25,=$11,where:LA= Line A incremental cash flow
Even though Line B generates more revenue than Line A, its resulting incremental cash flow is $5,000 less than Line A’s due to its larger expenses and initial investment. If only using incremental cash flows as the determinant for choosing a project, Line A is the better option.
Limitations of Incremental Cash Flow
The simple example above explains the idea, but in practice, incremental cash flows are extremely difficult to project. Besides the potential variables within a business that could affect incremental cash flows, many external variables are difficult or impossible to project. Market conditions, regulatory policies, and legal policies may impact incremental cash flow in unpredictable and unexpected ways. Another challenge is distinguishing between cash flows from the project and cash flows from other business operations. Without proper distinction, project selection can be made based on inaccurate or flawed data.
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