Incremental Cash Flows
Incremental cash flows are the net additional cash flows generated by a company by undertaking a project. Capital budgeting decisions are based on comparison of a project’s initial investment outlay to the future incremental cash flows of the project and its terminal cash flow.
Incremental cash flows are estimated by comparing the company’s net cash flows if the project is accepted and its cash flows if the project is not accepted. In making such estimation, it is important to consider the effect of acceptance of one project on the cash flows of another. In some cases, acceptance of a new project may result in reduction in cash flows of another, a phenomenon called cannibalization.
Discounting models of capital budgeting such as net present value and internal rate of return, compare the present value of future incremental cash flows and terminal cash flow with the initial investment outlay. If the present value of the future cash flows exceeds the investment required, the project is accepted, otherwise rejected. Non-discounting models, such as payback period, compare the face value of incremental cash flows with initial investment.
Estimating the incremental cash flows of a project is the first and arguably the most important step in the capital budgeting process.
LC, Inc. is a cement manufacturer with production facility in a South Asian country, which produces 10 million tons per annum, half of which is exported to Africa and Middle East. The company is interested in setting up a new plant in an African country with a capacity of 5 million tons per annum. The new plant will cater to the demand Africa and Middle East. However, it will result in reduction in export sales from its home country by 40%. The production not exported shall be sold in the domestic market. A ton of cement yields $100 ton in international market and $70 in the domestic market. Variable costs are $30 per ton in South Asia and $25 per ton in Africa. The company’s current fixed costs are $160 million per annum which will increase to $300 million if the new plant is established.
Estimate the annual incremental cash flows of the project.
The company’s management require a payback period of 7 years. If the initial investment outlay is $950 million, determine if it is a good investment.
We need to look at the before-project and after-project scenarios to determine the net increase in cash flows brought about by undertaking the new project.
Following is a comparison of current and proposed sales breakup:
|Domestic sales (in million tons)||5||7|
|Export sales from domestic plant (in million tons)||5||3|
|African plant sales (in million tons)||5|
Following is a calculation of annual incremental cash flows:
|Domestic sales (5 million * $70)||350||490||140|
|Export sales + African plant sales||500||800||300|
|Variable costs (domestic production) (10*30)||300||300|
|Variable costs (African production) (5*25)||0||125||125|
|Net cash flows (USD in million)||390||565||175|
|Payback Period =||$950 million||= 5.42 years|
Since the actual payback period of 5.42 years is less than the required payback period of 7 years, the company should invest in the project. However, it should also apply more sophisticated capital budgeting tools such net present value and internal rate of return.