Question

1. Explain what is meant by the incremental cash flow and tell me why the incremental cash flow is only relevant for the capital budgeting analysis.
2. Explain in detail what the weighted average cost of capital (WACC) is and the role it plays in capital budgeting.
3. What are flotation costs and why must they be included in the initial cost of a project? Explain in detail

Answer 1

Incremental Cash Flow :- Extra Cash Flow generated as a result of accepting a project. In other words we can say that change in total cash flow of the entity if we accept a project or we can say that extra cash flow arising because of project acceptance.

It plays an important role in making capital budgeting decisions. To accept or reject a project, initial investment of the project is compared with present value of incremental cash flows arising out of the project and terminal value, if the difference between the two is positive - project is accepted.

Calculation of incremental cash flow is the first and most important step in capital budgeting process.

Incremenal Cash Flow = Incremental Sales - Incremental operating expense + changes in non-operating expenses.

Incremental cash flow is only relevant in capital budgeting analysis because it ensures optimum utilisation of cash resources of the firm. Incremental cash flow is the base component while calculating the NPV of the project. The incremental cash flows is basically projected cash flows generated if the firm accepts the project. It is not used in other analysis because for other analysis mainly earning approach is taken as base (say for calculating ROI we take earning approach).

WACC and its role in Capital Budgeting Decisions -

The Capital Structure of company comprises of various sources of funds such as equity, shares, bonds,debts etc.Each of the components have different cost of capital. WACC is basically the weighted average cost of capital of each component of capital structure. Cost of capital of all sources (equity, shares, debt etc. ) is weighted to the total capital of the firm.

Its role in Capital Budgeting Decisions - In capital budgeting analysis, WACC is taken as the discount rate to calculate the net present value of future cash flows. It is used as discount rate to evaluate different alternate projects and the project having positive NPV is accepted. It is also said as the minimum required rate of the return company should recover from its project to ensure optimum utlisation of its resources.WACC is the marginal cost of additional investment.

WACC Formula - (Weightage of equity * cost of equity )+(Weightage of debt * cost of debt)* (1-tax rate) + (Weightage of prefernce shares * cost of preference shares)

Floatation costs :- The cost incurred in raising fund (through issue of debentures, bonds, securities etc) from the public. These costs are one time cost and incurred in the form of registration, legal, underwriting fees.

These costs are included in initial cost of the project because it is incurred to raise funds for the project.Flotation cost increases the cost of capital. For ex - 100 debentures issued at 10 and flotation cost incurred is 100 then my net flow from debenture issue is 1000-100 = 900. So here, my net inflow from issuing securities reduces resulting in increase in cost of capital.  In other words we can also say that the company needs to raise more funds than it need because of Flotation cost.

Flotation Cost Initial Outlay = Funds required/ (1-flotation cost as %)