QF5213 Chap.5 Relevant Incremental Cash Flows
Relevant Incremental Cash Flows
Why a project is judged on cash, not on profit
Once you know how to compute NPV and IRR, the harder question is what to feed into them. The answer is narrower than most first attempts assume. A project is worth exactly the change it makes to the firm's cash, measured in the period when that cash moves, after tax.
Accounting profit is a poor guide here because it deliberately smooths things out: a machine bought today is expensed bit by bit over its life, a sale on credit is booked before the customer pays, and a bill may be recorded long before it is settled. For a valuation, the machine is an outflow at time 0 and the receivable is an inflow only on collection.
Depreciation deserves special care.
It is not a payment to anyone, so it never belongs in the cash forecast as an outflow. It still matters, though, because the tax authority lets the firm deduct it, and that deduction lowers the tax bill.
The cash saved, the tax rate multiplied by the depreciation charge, is a genuine inflow often called the depreciation tax shield.
The single question that sorts every line item
Each candidate cash flow faces the same test: would it occur if the firm turned the project down? If not, it is incremental and goes in. If it would occur regardless, it stays out.
If only part of it is new, such as a utilities bill that rises slightly or overtime above the usual roster, only the increase counts. That test settles the categories students most often confuse. Money already spent on research or on a consultant cannot be recovered by either choice, so it is sunk and ignored.
Income an owned asset could earn elsewhere, such as rent on idle floor space, is an opportunity cost and is deducted, unless no outside use is actually available. Sales the new product steals from existing lines are charged to it as erosion, unless competitors would have taken those sales anyway, while extra sales of complementary products are credited to it.
Financing is the other common slip.
Interest and dividends stay out of the cash flows because the discount rate, the weighted average cost of capital, already charges for debt and equity. Subtracting them again counts the same cost twice.
Assembling the timeline
The class arranges every project's flows into three groups.
The initial outflow is the cost of fixed assets, including freight and installation, plus any immediate increase in net working capital. Operating flows during the life equal after-tax operating income plus depreciation.
The terminal flow collects the sale proceeds of the assets, the tax on any gain or the tax credit on any loss against book value, and the release of working capital as inventory, receivables and payables return to their earlier levels.
The case discussed in class, a running shoe launch with a new overseas factory, endorsement fees, lost sales of older models and an existing research bill, is a practical drill in applying all of these rules to a single forecast before any appraisal metric is computed.
What this chapter covers
- 01
Why appraisal uses cash timing instead of accounting profit
- 02
The with-and-without test for incremental cash flows
- 03
Sunk costs, opportunity costs and allocated overhead
- 04
Erosion and complementary sales as side effects
- 05
Why interest is left out when discounting at WACC
- 06
Net working capital invested at launch and recovered at the end
- 07
Operating cash flow, the depreciation tax shield and after-tax salvage
Worked example · free
Final-year cash flow when equipment sells below book value
- 2Compute the final-year operating cash flow using the tax shield form
- 2Compute the after-tax salvage value, recognising the tax credit on the loss
- 1Add the working capital recovery and state the total
Key terms
- Incremental Cash Flow
- The difference between the firm's cash flow with the project and its cash flow without it, the only flow that belongs in NPV.
- Sunk Cost
- An expense already incurred that no decision can reverse, so it is identical in both scenarios and is left out of the appraisal.
- Opportunity Cost
- Income an asset the firm already owns could earn in its best alternative use, deducted from the project that takes the asset over.
- Erosion
- Lost cash margin on the firm's existing products caused by a new product taking their customers, charged against the new project.
- Net Working Capital
- Current assets such as inventory and receivables minus current liabilities such as payables, an investment that is usually recovered at project end.
- Depreciation Tax Shield
- The tax saved because depreciation is deductible, equal to the tax rate times the depreciation charge, and treated as a cash inflow.
- After-Tax Salvage Value
- The sale price of a project asset adjusted for tax on the gain or credit on the loss relative to its book value.
Relevant Incremental Cash Flows FAQ
Should sunk costs be included in NPV?
No. A cost already paid, such as last year's research or a consultant's report on the project, is the same whether the firm accepts or rejects. Adding it makes good projects look bad and can lead you to reject an investment that would recover part of an unavoidable loss.
Why is interest expense not deducted from project cash flows?
Because the cash flows are discounted at the weighted average cost of capital, and that rate already compensates lenders and shareholders. Taking interest out of the forecast as well charges the financing cost twice, so NPV comes out too low and sound projects may be rejected.
How do I treat an increase in net working capital in capital budgeting?
Record the net rise in inventory and receivables minus the rise in payables and accruals as an outflow when it happens, usually at launch. When the project ends those balances return to normal, so the same amount is entered as an inflow in the final year.
Is depreciation a cash flow or not?
Depreciation itself is not cash, so it is never an outflow in the forecast. Its effect on tax is cash, though. If you start from profit after tax you add depreciation back; if you start from cash revenue minus cash costs you add the tax rate times depreciation instead.
When does cannibalization not count against a new product?
Only lost sales the new product actually causes are charged to it. If older models would lose those customers anyway, for example because competitors are releasing replacements, the decline happens with or without the launch and should be left out of the new product's cash flows.
Exam move
Take any project question and, before calculating anything, list every number in the prompt down one column. Beside each, write include, exclude or partial, with a one-word reason: sunk, opportunity, erosion, financing, overhead, working capital or salvage. Then rebuild the forecast in three blocks: initial, operating, terminal.
Practise this on two or three past problems until the sorting takes under two minutes, because most errors happen in the sorting, not the discounting.
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