Estimating incremental cash flows
Written by:Abraham A.Estimating incremental cash flows is explained and illustrated with example calculation using the estimating incremental cash flows formula. Learn how incremental free cash flows in capital budgeting are arrived at with initial outlay + interim cash flows + terminal cash flow. The process details the steps required to arrive at free cash flows FCF that are used in discounted cash flow analysis to evaluate investments with IRR, MIRR, NPV, Discounted payback period, and benefit cost methods.
Incremental Cash Flow
There are three parts to preparing or estimating free cash flow that you need to find any of the capital budgeting metrics such as IRR, MIRR, NPV, Payback Period and Profitability Index. Keep in view it is not the profits or revenues that we use but after tax free cash flow.
The cash flows may be divided in to three categories- Initial Incremental Cash Out flow
- Interim Incremental Cash Flows
- Terminal Incremental Cash flow
Initial Incremental Cash Flow
Here we consider cost of the new equipment, replacement equipment, or any other capital investment we are about to embark on. We add capital expenditures from the invested amount ( such as cost of installation, cost of shipment, or what you may call carriage expense, and other expenses directly related to the installation or purchase of the equipment.
A good number of capital projects will require an increase in net working capital such as cost of inventory, rack space, etc. We need to make sure that we do not include sunk costs ( for example any costs or expenses already accrued which were inevitable regardless of whether we undertook this project or not. The increase or decrease in net working capital would be added or deducted from the initial investment.
Another point to keep in mind is that we must consider the opportunity costs or marginal costs, in our cash flow estimation. A good example of this would be rent received from the space allocated for the new equipment in case we did not undertake the project, this is sort of an example that highlights the opportunity cost of the resources associated with the capital project. So we will need to make room for such opportunity costs in our initial cash outlay.
If we were considering a replacement decision for an equipment, or machinery we will need to deduct the proceeds from sale of such old equipment while deducting any tax expenses or adding tax exemptions from the sum.
At this juncture we have prepared ourselves the figure for initial cash outlay. As for the net working capital, we will get that amount back in the terminal cash flow.
Interim Incremental Cash Flows
Here we start off with the amount of net savings from installation of new equipment or net increase or decrease in operational revenue from installation of such equipment. We will add or subtract any net decrease or increase in operating expenses other than depreciation. Now we can add or subtract net decrease or increase in tax depreciation ( a non cash expense ) which will add back after getting an after tax cash flows. We will deduct or add decrease or increase in tax liabilities. And finally adding back the depreciation charges to get the free interim cash flows.
Terminal Incremental Cash Flow
Terminal Cash Flow is a special case as there are other things to be considered than those in interim cash flows. The incremental interim cash flows figures need to be adjusted for the terminal year. If the equipment has any residual or salvage value we will add or subtract reclaimation or disposal costs. If there were any tax savings or expenses associated with the disposal or reclaimation of the old equipment will deduct or add these. Finally any increase or decrease in net working capital we considered in the initial cash outlay is adjusted here by either adding or subtracting the decrease or increase in net working capital. This final figure is our terminal year incremental net cash flow.
