Incremental cash flows

Reference E3 (d) of the FFM study guide requires candidates to be able identify/evaluate relevant cash flows for investment decisions. The identification of relevant cash flows is also examined in higher level papers.

Definition

A definition often used for relevant cash flows states that they must be cash flows that occur in the future and are incremental.

Cash flow
While on the face of it obvious, only costs and revenues that give rise to a cash flow should be included, so for example, depreciation charges should be excluded.

Future
Any relevant cash flow should arise in the future. Anything that has occurred in the past is referred to as a sunk cost and should be excluded from relevant cash flows.

Incremental
Only cash flows that arise because of the decision being made should be included; any cash flow that would have arisen anyway, sometimes referred to as a committed cost, should be excluded.

Candidates can often struggle to pick up the incremental cash flows within a question, and it is this element of the definition that this article will concentrate on.

Example
Let us consider an easy example:

Zob Co is considering investing in a new project to produce the Elfin.

The machine required to produce the Elfin will cost $400,000 which is payable immediately. It will have a life of four years, at the end of which the scrap value will be $5,000.

The following budgeted information is available:

• 1,500 units will be sold each year for $125 per unit, giving rise to revenue per year of $187,500.
• Variable costs per unit will be $21, giving rise to a total variable cost of $31,500 per year.
• Rent and rates of $1,200 will be allocated to the new product each year.

What are the incremental cash flows associated with this project?

Incremental cash flows
So we are looking for the incremental cash flows for the project – ie those cash flows that will arise because the project is being taken on.

In this case, the initial investment of $400,000 and the scrap value of $5,000 are both incremental cash flows as they only arise if the project is taken on and the Elfin made. The initial investment is an outflow, the scrap value is an inflow.

Similarly, the revenue of $187,500 per year and the variable costs of $31,500 per year are also incremental cash flows. These cash flows will only arise if the Elfin is made and sold. The revenue is an inflow, the variable costs are an outflow.

However, the rent and rates are not incremental to the project. These costs have been allocated to the project. The company, Zob Co, will have to pay the rent and rates whether or not the Elfin is made, and therefore they are not incremental cash flows.

Example extension
Candidates often cope better with the more straightforward scenarios as we have above, but what if the scenario is more complicated?

Using the same example as before, but adding some extra information (shown in bold):

Zob Co is considering investing a new project to produce the Elfin.

The machine required to produce the Elfin will cost $400,000 which is payable immediately. It will have a life of four years, at the end of which the scrap value will be $5,000.

The following budgeted information is available:

• 1,500 units will be sold each year for $125 per unit, giving rise to revenue per year of $187,500.
• Variable costs per unit will be $21, giving rise to a total variable cost of $31,500 per year.
• Rent and rates of $1,200 will be allocated to the new product each year.

During the installation of the new machine, Zob Co could pay $20,000 for a modification to be made which would increase the efficiency of the machine. The modified machine would have a scrap value of $6,000 in four years time. The modification would allow the annual output to increase to 1,650 units, and the variable costs per unit to reduce by 5% across all production. All the increased output can be sold.

What are the incremental cash flows arising from the modification?

Incremental cash flows
The requirement here is not for the incremental cash flows of the project, but the incremental cash flows arising from the modification. We are looking for those cash flows that will arise if the modification is completed. The question to ask ourselves every time is 'what is the extra cash flow that will arise if modification takes place?'

In this case, the $400,000 purchase cost is not an incremental cash flow, the cost of $400,000 will be paid whether or not the modification is completed.

The $20,000 modification cost is an incremental cash outflow as it only has to be paid if the modification goes ahead.

Looking at the cash flows in relation to the scrap value, if modification does not take place, the cash flow will be $5,000, but if the modification does take place, the cash flow will be $6,000. So the incremental cash flow arising for the modification – ie the extra cash flow that will arise if modification takes place,  is the difference of $1,000. This will be a cash inflow, as an extra $1,000 will be received in scrap value if the modification goes ahead.

Some candidates find the incremental cash flows in a scenario like this easier to calculate if they follow the proforma:

Candidates then have to consider if the incremental flow is a cash inflow or a cash outflow.

So in the case of the scrap value:

Now to consider the signage of the incremental flow. If the modification takes place, Zob Co will receive an extra $1,000 of income, so the incremental cash flow is an inflow.

Now let us consider the increased output - this will affect both revenue and variable costs.

If the output is increased, the revenue will be increased (we are told that all output can be sold).

The incremental revenue that will arise if the modification is made will be equal to the extra units that can now be made and sold (150)  multiplied by the revenue per unit of $125, giving an incremental cash flow of $18,750.

Using our proforma:

Considering the signage of the incremental flow, if the modification occurs, then Zob Co will receive extra revenue, and so the incremental cash flow is an inflow.

Let us now consider variable costs, where there are two different effects of the modification to consider:

• variable costs will rise because more units are being made
• variable costs per unit will fall because the increased efficiency of the machine. Note we are told that this fall in variable cost per unit will occur over all of the output.

In a situation like this, it is often easier to use the proforma:

This incremental flow is an outflow. If the modification goes ahead, Zob Co will have to pay $1,417.50 more in variable costs.

The allocated fixed costs are still not incremental as explained earlier.

So in summary the incremental cash flows for the modification are:

These cash flows can then be used further to, for example, decide if the modification should take place, by calculating the net present value of the incremental flows.

Conclusion

It is hoped that this article, will help students identify the incremental cash flows that arise due to the decision being made, and so aid them in their examination preparation.