Key takeaways
What this article covers, in order:
- The with-and-without test
- The components of a project's incremental cash flow
- Worked example: a new product line at a drinks maker
- Common mistakes
- hellobooks-helps">How HelloBooks helps
Incremental cash flow is the difference between the company's cash flows if it takes a decision and its cash flows if it does not. The formula is simply incremental cash flow = cash flows with the project − cash flows without the project, measured after tax, period by period. Only cash that changes because of the decision is relevant: past spending, allocated overheads that stay the same, and interest on the money used to fund the project are all left out.
This guide explains which items count, how to lay out a project schedule, and works through a five-year example to a net present value.
The with-and-without test
Every item in a project appraisal should pass one test: would this cash flow be different if we went ahead? If yes, include the difference. If no, leave it out, however closely it seems related to the project. Applying that test consistently produces the four standard rules below.
Exclude sunk costs
Money already spent, or already committed and unrecoverable, is the same whichever way you decide. A feasibility study, market research or a prototype paid for last quarter is a sunk cost. Including it makes good projects look worse and can lead to the classic error of continuing a weak project because so much has already been spent.
Include opportunity costs
If the project uses something the company already owns — a building, a machine, a team's time — and that resource could otherwise earn cash, the cash given up is a relevant cost. Using an empty warehouse that could have been rented out is not free; the lost rent belongs in the analysis.
Include side effects on existing products
A new product can take sales from an existing one (cannibalisation) or boost them (a complementary product). Either way, the change in the existing business's cash flow is incremental and belongs in the project's numbers.
Exclude financing costs
Interest and loan repayments are left out of the cash flows because the cost of capital is captured in the discount rate. Deducting interest and then discounting at a rate that already reflects the cost of debt would count financing twice.
The components of a project's incremental cash flow
Most capital-budgeting schedules split cash flows into three groups:
- Initial investment — purchase and installation of equipment, plus any up-front investment in working capital such as stock and receivables.
- Annual operating cash flow — incremental revenue minus incremental cash costs, including opportunity costs and side effects, less the tax on the resulting profit, with depreciation counted only for its tax effect.
- Terminal cash flow — the after-tax proceeds from selling the equipment at the end, plus recovery of the working capital invested at the start.
A convenient formula for the annual figure is operating cash flow = (incremental revenue − incremental cash costs) × (1 − tax rate) + depreciation × tax rate. The second term is the depreciation tax shield: depreciation is not a cash cost, but it reduces taxable profit and therefore tax paid.
Worked example: a new product line at a drinks maker
Brightwater Bottling, a regional drinks company, is deciding whether to launch a sparkling-water line. The tax rate is 25% and the company uses a 10% discount rate for projects of this risk. Illustrative figures:
- Market research already completed — $40,000
- New carbonation and filling equipment — $500,000, depreciated straight-line to zero over five years ($100,000 a year)
- Expected sale value of the equipment after five years — $50,000
- Extra stock and receivables needed from day one — $60,000, recovered at the end of year five
- Annual sales of the new line — $600,000
- Variable costs — 40% of sales, so $240,000
- Extra fixed costs (a line supervisor, maintenance contract) — $80,000 a year
- Warehouse space the line will use, currently rentable to a tenant — $30,000 a year of lost rent
- Lost contribution from existing still-water sales that customers switch away from — $50,000 a year
- Interest on the loan used to buy the equipment — $35,000 a year
- Share of head-office costs the finance team will allocate to the line — $45,000 a year, though head-office spending will not change
Step 1: Decide what is relevant
- Market research of $40,000 — exclude, it is sunk.
- Loan interest of $35,000 — exclude, financing is in the discount rate.
- Allocated head-office cost of $45,000 — exclude, total spending does not change.
- Lost rent of $30,000 and lost still-water contribution of $50,000 — include, both change because of the decision.
Step 2: Annual operating cash flow
- Sales — $600,000
- Less variable costs — $240,000
- Less extra fixed costs — $80,000
- Less lost rent — $30,000
- Less lost still-water contribution — $50,000
- Incremental cash profit before tax — $200,000
- Less depreciation — $100,000, giving taxable profit of $100,000
- Tax at 25% — $25,000
- Operating cash flow = $200,000 − $25,000 = $175,000 a year
Check with the shortcut formula: $200,000 × 0.75 + $100,000 × 0.25 = $150,000 + $25,000 = $175,000.
Step 3: Initial and terminal cash flows
- Year 0: equipment $500,000 plus working capital $60,000 = outflow of $560,000
- End of year 5: the equipment is fully depreciated, so the whole $50,000 sale price is a taxable gain. After-tax proceeds are $50,000 × (1 − 0.25) = $37,500.
- Working capital recovered — $60,000
Step 4: The incremental cash flow schedule
- Year 0 — minus $560,000
- Years 1 to 4 — $175,000 each year
- Year 5 — $175,000 + $60,000 + $37,500 = $272,500
Step 5: Net present value
Discounting at 10%, the present value of $175,000 a year for five years is about $663,388, and the present value of the extra $97,500 received in year five is about $60,540. Total present value of inflows is about $723,928, so NPV is about $163,928. At a 12% discount rate the NPV falls to about $126,160 — still positive.
Notice what would have happened with the wrong inputs. Deducting the $40,000 of research, the $35,000 of interest and the $45,000 of allocated overhead would have understated annual and initial cash flows and could have made a sound project look marginal. Leaving out the lost rent and cannibalised sales would have overstated annual pre-tax cash flow by $80,000.
Common mistakes
- Using accounting profit instead of cash flow. Profit includes depreciation and accruals. Appraisals need the timing of cash.
- Forgetting working capital. Extra stock and receivables tie up cash at the start; the recovery at the end is easy to miss.
- Counting allocated overheads. Only overheads that actually rise because of the project are incremental.
- Ignoring tax on the sale of equipment. Proceeds above the asset's tax written-down value are usually taxable; proceeds below it may create a deductible loss. Tax rules for disposals vary by country, so check yours.
- Mixing nominal and real figures. If cash flows include inflation, the discount rate must too.
hellobooks< / a > -helps">How HelloBooks helps
Good project appraisals start from good cost data. HelloBooks lets you tag income and expenses by class, location or project, so you can see what a product line, branch or contract actually costs once it is running and compare it with the original appraisal using budget vs actual reports. The fixed assets register records the equipment and calculates straight-line or WDV depreciation, and the CFO dashboard and cash flow statement show the effect on company-wide cash. Export the tagged data to CSV to build or refresh your incremental cash flow model. The appraisal itself — and the judgement about which costs truly change — stays with you and your finance adviser.
