Note that sometimes we just say “incremental cash flow”.
In capital budgeting, incremental free cash flow refers to the additional cash flow a company expects to generate (or lose) as a direct result of taking on a new project or investment. Only include cash flows that change because of the project. If it happens regardless of the project (like sunk costs), leave it out.
Free cash flows are cash flows that are free to be distributed to a company’s debtholders and shareholders. It’s the cash left after paying for operating costs, taxes, capital expenditures, and changes in working capital. So this is the money that’s free for paying dividends, paying down debt, reinvesting in the business, or share buybacks.
Estimating Incremental FCF
To estimate each incremental cash flow:
- Start by estimating the incremental earnings of a project
- How the investment decision will affect the firm’s reported profits from an accounting perspective
- Information from pro forma income statement
- Convert earnings to cash flows.
Pitfalls
Determining Relevant Cash Flows
- Incremental cash flows
- consist of any and all changes in the firm’s future cash flows that are a direct consequence of undertaking the project
- Should include all changes between the firm’s free cash flows with the project vs without the project.
- Cash flows that will occur if and only if the project is undertaken
- Cash flows that will occur regardless if the project is undertaken are NOT relevant
- Asking the right question:
- Will the CF arise if you invest in the project?
- Will the CF arise if you do not invest in the project?
Opportunity Costs
- No “free lunch”
- Costs of lost options – Opportunities forgone due to the project
Project Externalities
Positive (Synergy) or negative effects (Cannibalization) on other existing projects of the firm
- A new product may increase sale of existing products.
- Cannibalization is when sales of a new product displaces sales of an existing product.
Sunk Costs
- Fixed Overhead Expenses
- Overhead costs that are fixed and not incremental to the project should not be included.
- Past Research and Development Expenditures
- Money that has already been spent on R&D is a sunk cost and therefore irrelevant to the project.
- The decision to continue or abandon a project should be based only on the incremental costs and benefits of the project going forward.
- e.g., Cisco Systems has completed a $300,000 feasibility study to assess its attractiveness. Should this be included in calculating the incremental earnings?
- Unavoidable Competitive Effects
- When developing a new product, firms often worry about the cannibalization of their existing products. But if sales are likely to decline in any case as a result of new products introduced by competitors, then these lost sales are a sunk cost and we should not include them in our projections.