Incremental cash flows

Incremental cash flows are the additional cash flows that occur as a direct consequence of taking on a new project. They are unique to the project and are measured on a stand-alone basis.

Standalone basis evaluation means that:

Only the CFs directly related to the project are considered
The focus is on identifying the cash flows that would be incurred if the project is accepted and those that would not exist if the project is rejected.

They must be estimated over the economic life at the project and measured at the time the cash flows will occur.

Incremental cash flows are considered because they represent the additional cash generated by the project, helping in evaluating its viability and profitability on a stand-alone basis.

Opportunity costs

Opportunity cost is considered an ICF. It is the most valuable alternative given up if the particular investment is undertaken.

Examples include potential cash inflows from selling an asset or income from renting out an asset that is instead used for the project.

To calculate the opportunity cost from not selling an asset, it is calculated as the expected proceeds from the sale of the asset, net of any taxes (e.g., capital gains tax).

For example:

We own undeveloped land previously acquired for $5M, which can be solved for $40M.
Capital gains (investment profit) is taxed at 20%
In assessing the viability of the project, we would take:
40M of positive cash flow from selling property
(40M - 5M) x 20% = 7M of negative cash flow from taxes
Hence, 33M of opportunity costs

Changes in Net Working Capital

Incremental Net Working Capital is a change a change in NWC over one period.

The change in NWC represents extra capital required to sustain the increase/decrease in business activities from one year to the next.

When there is an increase in Inventory and Accounts Receivable, this requires additional cash outflows and thus represents a drain on cash flows. Conversely, an increase in Accounts Payable represents a deferment of cash outflows / an increase in current liabilities and thus a decrease in net working capital.

A reduction in NWC increases project cash flows because:

Less cash is tied in operations - fewer resources is being used in inventory, receivables, etc
Increase in Accounts Payable means the company retains cash longer by delaying payments to suppliers. This means the company retains cash longer and improves cash flow

Adding back incremental NWC

Working capital investments need to be added back at the end of the project life.

When incremental (net) working capital is positive, excluding working capital will overstate project cash flows and makes the project look more valuable than it is.

Incremental NWC > 0 indicates a cash outflow. Excluding incremental NWC will omit money invested and hence overstate cash flows.

At $T = 0$ project start, $N W C = 1000$ , $I n c N W C = 1000$ : initial working capital and initial cash flow

At $T > 0, T < e n d$ , $N W C = 1000$ , $I n c N W C = 0$ : No additional investment, no change in NWC

At $T = e n d$ , $N W C = 0$ , $I n c N W C = - 1000$

The company recovers the entire $1000 invested in working capital, and is considered cash inflow as the working capital is released. This is a result of:

Remaining receivables collected
Remaining inventory sold
Outstanding payables are settled

Working capital investments are recovered or "salvaged" at the end of the project life as the business operations are wound down, releasing the funds tied up in net working capital back into cash.

! SUNK COSTS, FINANCING COSTS, DEPRECIATION ARE NOT INCREMENTAL CASH FLOWS.

Sunk costs

Sunk costs are expenses that have already been incurred and cannot be recovered regardless of future decisions.

As they are past expenditures unaffected by decisions to undertake or forego the project, they are not considered incremental cash flows.

For example:

Testing markets for consumer products
R&D expenses

Financing costs

Financing costs include interest payments and dividends paid to shareholders.

Financing costs are cash flows to the investors, not cash flows from the project.

Account for financing costs with the project's cost of capital $r$ , the rate used to discount the project cash flows. Not to be confused with interest rate $r$ .

Capital includes loan proceeds or additional money raised from investors.

Depreciation

Depreciation is used to reduce the gross value of fixed assets, to reduce taxes.