Question

When estimating the FCF of a project, you are expected to estimate “incremental” FCF – explain what the phrase “incremental” means and why you need to calculate the “incremental” FCF to evaluate a project?

What three attributes of these incremental FCFs matter? How are these attributes incorporated in the capital budgeting process?

Answer 1

When a new project is proposed for capital budgeting it is associated with cash flows which are called Incremental Cash flow. Hence incremental cash flow is the excess operating cash flow that an organization receives from a new project proposal. Positive incremental cash flow means the company's operating cash flow will improve whereas decline in operating cash flow for vice-versa. Hence the positive incremental cash flow is a good initial sign for a project.

So for evaluating a project we calculate the net present value by finding the present value of all the estimated incremental cash flows and then subtracting from the present value of all the cash outflows. If the NPV is positive then the project is accepted, if negative then the project is rejected, and if zero then it depends on the management to accept or reject as it becomes indifferent.

So the incremental cash flow is important for the acceptance or rejection of a project.

Three Attribute of Incremental Cash Flows:

Initial Outlay - The initial cost of the project or the money required for the setup

Cash Flows from the project - The intermediate cash flows generated by the operation

Terminal Value - The salvage value or the inflows generated by the disposal of the equipment used in the project

In capital budgeting the Initial Outlay helps in the estimation of operating and implementation cost. The projected cash flows helps in calculation of NPV which is used for decesion making.