Cannibalization is when acceptance of a new project is expected to decrease cash flows of an existing project.
In order to make educated capital budgeting decisions, businesses need to correctly incorporate the effect of cannibalization in calculation of measures such as net present value, internal rate of return, discounted payback, profitability index, etc.
Crispy Potatoes specialize in manufacture of potato chips and other potato products. It is currently producing and selling two versions of chips: salty and French cheese. It plans to introduce a spicy flavor. It expects 20% of customers that currently purchase salty chips to switch to spicy ones while 5% of French cheese buyers are expected to buy spicy ones. This is cannibalization and Crispy Potatoes has to show the lost cash flows from drop in sales of salty and French cheese versions as cost of the new product.