Incremental Cash Flow

When evaluating an investment, the key question is how the company's future cash flows will change if it goes ahead. Only cash flows that would not happen otherwise should be counted.

Incremental cash flows include the initial investment, extra revenues, extra operating costs, changes in working capital, taxes and any cash received when the project ends, such as from selling equipment.

For example, a company launching a new product expects it to bring in 500,000 a year in sales, but it will also reduce sales of an existing product by 100,000. The incremental revenue is 400,000, not 500,000.

Some cash flows should be excluded. Sunk costs, such as money already spent on research, are irrelevant because they cannot be recovered. Fixed overheads that will continue regardless of the decision should not be counted. Opportunity costs, such as income from renting out a building the project will now use, should be included.

Incremental cash flows form the basis of capital budgeting tools such as net present value and internal rate of return. Getting them right is essential for making sound investment decisions.