Capital budgeting

Incremental cash flows

Decide which cash flows belong in a project appraisal: sunk costs out, opportunity costs and side effects in.

18 minintermediateFree lesson

Learning objectives

Identify the incremental cash flows of a project decision
Exclude sunk costs, allocated overheads and financing costs
Include opportunity costs, cannibalisation and working capital
Build a project's incremental cash flows and NPV in a worksheet

A project appraisal asks one question: how does the company's cash change if it goes ahead, compared with if it doesn't? NPV is only as good as the cash flows you feed it, and most appraisal errors are not discounting mistakes. They are the wrong items in the cash flow line: a cost already spent, an overhead that exists anyway, or a lost sale nobody counted.

The rule is simple to state: include a cash flow if, and only if, it changes because of the decision.

Incremental cash flow

ΔCF = CF(company with the project) − CF(company without the project)

Sunk cost: already spent or committed whatever you decide — exclude
Opportunity cost: cash an asset you already own would earn in its best other use — include as a cost
Side effects: sales lost on existing products (cannibalisation) or gained elsewhere — include
Allocated overhead: existing costs re-spread across projects — exclude unless total overhead actually rises
Financing costs: interest and dividends — exclude; the discount rate already charges for capital
Working capital: cash tied up in stock and receivables — include when invested and when recovered

Worked example

A café adds a delivery service (fictional, SAR thousands a year)

The owner of a small café expects delivery revenue of 240 and delivery costs (drivers, fuel, packaging) of 150. Some regulars will order in rather than visit, costing 18 of in-store contribution. The delivery team will use a back room the café currently sublets for 9 a year. A market survey last month cost 12, and the accountant would charge the service 20 of the café's existing rent.

Item	Relevant?	Annual cash flow
Delivery revenue	Yes	240
Delivery costs	Yes	−150
Lost in-store contribution	Yes (cannibalisation)	−18
Sublet income given up	Yes (opportunity cost)	−9
Market survey	No (sunk)	—
Share of existing rent	No (paid anyway)	—
Incremental cash flow		63

Counting the survey and the rent share would understate the service by 12 once and 20 a year; ignoring the lost regulars and the sublet would overstate it by 27 a year.

A method that works on any project. Write the assumption list down, then put each item through the same test: would this cash flow be different if we said no?

Direct flows (new sales, new costs, new equipment): in.
Effects on the rest of the business (lost or gained sales on existing products, an asset you already own that the project will occupy): in, valued at what the company actually gives up.
Spent or committed money (studies, past development, contracts you can't exit): out.
Accounting allocations (shared rent, head-office charges): out, unless the total actually rises.
Financing (interest, loan repayments, dividends): out; the discount rate deals with them.

Two edge cases trip people up. Cannibalisation only counts if those sales would otherwise have stayed with the company: if a competitor is about to take them anyway, the loss happens with or without the project and is not incremental. And an opportunity cost is the asset's best realistic alternative use, not a hopeful one.

Concept check

Exercise 1

Check your understanding

A company spent SAR 400k last year on engineering studies for a new plant. The board now asks whether to build it. How should the SAR 400k enter the appraisal?

Ignore it: it has been spent whatever the board decides.Deduct it at year 0, because the project caused it.Add it back, because it reduces the remaining cost.Spread it over the plant's life as an annual cost.

Calculation

Exercise 2

Calculate

A fitness club (fictional) is considering a juice corner. In SAR thousands a year: juice sales 150, juice costs 95, contribution lost at the club's existing snack counter 12, and the corner is currently rented to a physiotherapist for 18. A design consultant was paid 7 last month, and the manager's salary (unchanged) would be allocated 15. What is the juice corner's annual incremental cash flow?

Your answer

Sahel Foods juice line: net incremental cash flow (SAR thousands)

Data

	Net incremental cash flow
Year 0	-1.4k
Year 1	435
Year 2	435
Year 3	435
Year 4	655

The chart shows the cash flows you will build in the challenge for Sahel Foods, a fictional juice maker. Year 0 carries the equipment and the working capital; year 4 adds back the resale value and the working capital recovered. At 10% the project's NPV is 109.2. Load it with the sunk study, the allocated overhead and the loan interest, and the NPV becomes −280.5: a good project rejected for the wrong reasons.

Worksheet

Exercise 3

Challenge: Sahel Foods' incremental cash flows

Sahel Foods (fictional) is deciding whether to add a juice line. Using only the relevant assumptions, fill in the cash flows for years 0–4 (outflows negative), the net incremental cash flow each year and the NPV in B19. Three of the items listed are not incremental: leave them out.

0/14 cells entered · Ctrl+. jumps to the next empty cell

B15

	A	B	C	D	E	F
1	Assumptions (SAR thousands)	Value
2	Equipment cost (year 0)	1,300
3	Feasibility study (paid last year)	60
4	Annual sales of the new line	1,200
5	Annual operating costs of the new line	640
6	Contribution lost on existing juices	80
7	Warehouse rent forgone each year	45
8	Head-office overhead allocated	50
9	Interest on the equipment loan	54
10	Working capital (year 0, recovered year 4)	120
11	Equipment resale value (year 4)	100
12	Discount rate	10.0%
13	No corporate tax in this lesson. Outflows are negative.
14	Incremental cash flow	Year 0	Year 1	Year 2	Year 3	Year 4
15	Equipment and resale
16	Working capital
17	Operating cash flow
18	Net incremental cash flow
19	NPV at the discount rate

InputYou build (dashed while empty)Given, lockedYear 0 · Equipment and resale

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