Incremental cash flows

Incremental cash flow refers to the net after tax cash flow that is generated by a project during its life. The incremental cash flow equals sales minus the operating expenses. Since the company is thinking of launching a new product, the decision should be made based on the incremental cash flows.

Incremental cash flow is calculated as:

Incremental Cash Flows = Cash Inflows − Cash Outflows − Taxes

Taxes = (Inflows − Outflows − Depreciation Expense) × Tax Rate

For year 1, the cash inflows = $950,000

For the consecutive years, the cash flow = $1,500,000

Direct cost (labor and materials) = 55% of sales which will be $ 522,500 in the first year and $ 825,000 for consecutive years.

Indirect incremental costs are estimated at $80,000

New plant costs = $1,000,000

Additional net investment in inventory and receivables = $200,000

Marginal tax rate = 35%,

Cost of capital is 10%.

Incremental Cash flows = Cash Inflows − Cash Outflows − (Inflows − Outflows − Depreciation) × Tax Rate

Depreciation expense = $1,000,000/5= $200,000

Taxes for year 1 = (950,000 – 522,500 – 200,000 – 80,000) x 35% = $ 51,625

Incremental cash flow for year 1 = (950,000 – 200,000 –51,625) = $ 698,375

Taxes for consecutive years = (1,500,000 – 825,000 – 200,000 – 80,000) x 35% = $ 138,250

Incremental cash flow for 7 consecutive years= (1,500,000 – 200,000 – 138250) = $ 1,161,750

The payback period (P/B) and the net present value (NPV)

Payback period refers to the period of time needed to recover the cost of investment. The payback period is calculated as:

P/B= Cost of project/ annual cash inflows

The cost of the project for the first financial year is = $(1,000,000 + 522,500 + 200,000) =$ 1,722,500.

The expected annual return for the first financial year is $950,000.

P/B= 1,722,500/950,000 = 1.81.

The payback period will be 1.81 years.

For the consecutive years, the payback period will be 1,000,000 + 825,000 + 200,000 = $ 2,202,500

2,202,500/1,500,000 = 1.47 years.

Year | Expected cash flow $ |

1 | 950,000 |

2 | 1,500,000 |

3 | 1,500,000 |

4 | 1,500,000 |

5 | 1,500,000 |

6 | 1,500,000 |

7 | 1,500,000 |

8 | 1,500,000 |

The cost of the project will therefore be recovered by the end of the second financial year.

The net present value (NPV) refers to the expected future cash flows minus the initial investment. NPV is defined as the present value of the stream of cash flows of a project less the net investment. Also known as discounted cash flow (DFC), the net present value represents the contribution of an investment to the value of a company and the wealth of the company’s stakeholders. The cash flows are discounted as the cost of capital. The cost of capital refers to the minimum acceptable rate of return of projects involving average risks.

The net present value is calculated as:

NPV = PVNCF – NINV, whereby PVNCF is the present value of net cash flows and NINV is the net investment.

For even cash flows, NPV = R × {1 − (1 + i)-n}/i − Initial Investment

For uneven cash flows, NPV ={R1/(1 + i)1 +R2/(1 + i)2+R3/(1 + i)3+ …}− Initial Investment

For uneven cash flows as it is in this case, the present value (PV) for each year will be calculated as:

Year 1= 1/ (1+10%)1 = 0.9091

Year 2= 1/ (1+10%)2 = 0.8264

Year 3 = 1/ (1+10%)3 = 0.7513

Year 4 = 1/ (1+10%)4 = 0.6830

Year 5 = 1/ (1+10%)5 = 0.6209

Year 6 = 1/ (1+10%)6 = 0.5645

Year 7 = 1/ (1+10%)7 = 0.5132

Year 8 = 1/ (1+10%)8 = 0.4665

Year | Expected cash flow $ | PV factors | Present Value of Cash Flows= Cash Flow × Present Value Factor |

1 | 950,000 | 0.9091 | 863,645 |

2 | 1,500,000 | 0.8264 | 1,284600 |

3 | 1,500,000 | 0.7513 | 1,126,950 |

4 | 1,500,000 | 0.6830 | 1,024,500 |

5 | 1,500,000 | 0.6209 | 931,350 |

6 | 1,500,000 | 0.5645 | 846,750 |

7 | 1,500,000 | 0.5132 | 769,800 |

8 | 1,500,000 | 0.4665 | 699,750 |

The total PV of cash flows = $ 7,547,345

The initial investment was = $1,000,000

The NPV= $ 7,547,345- $1,000,000 = 6,547,345

From the calculations of P/B and NPV, the project should be accepted as the NPV has a positive value. The project will also be able to recover the initial costs by the end of the second year. The positive NPV shows that the project is highly likely to increase in value and increase the stakeholders and company’s wealth.

If the company has a P/B (payback) policy of not accepting projects with life of over 3 years, then the project would still be viable as the initial costs of the project would be recovered within the first two financial years and by the end of the second year, the company will be making profits.

If the project required additional investment in land and building, the initial investment costs would be higher and this would push the payback period further. This means that it would have taken a longer period for the company to recover its money. If the company maintained the P/B (payback) policy of not accepting projects with life of over 3 years, then the project would not be accepted as it would have taken at least three years to recover the initial costs.