incremental principle

8/3/2019 Incremental Principle

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To ascertain a project’s incremental cash

flow, it is required to check the cash flows of

firm with the project and without the project .The difference between the two reflects theincremental cash flows attributable with theproject ie.

Project cash flow for the year t=(cash flow forthe firm with project for year t)-(cash flow forthe firm without the project for the year t)



In estimating the incremental cash flows,thefollowing points must be borne in mind:

All incidental effects Ignore sunk costs Include opportunity costs Allocation of overhead costs Estimate working capital properly



In addition to the direct cash flows of project, all itsincidental effects must be considered. It may:

1. Enhance complementary activities of the firm.

2. Detract from profitability of some of the existingactivities of firm for competitive relationship.

Another effect may be effect of product

cannibalisation:The erosion in sales of firms existingproducts on account of new product introduction.Thismay lead to negative incremental effect of new productas profitability decreases.If the firm is operating in anextremely competitive business and is not protected by

entry barriers product cannibalization will occur anyway.



A sunk cost refers to an outlay alreadyincurred in the past. So it is not affected by

acceptance or rejection of the project underconsideration. Sunk costs are thus ignored asit cannot be recovered irrespective of whether the project is accepted or not andhence are not relevant for decision making



The opportunity cost of a resource is the benefit that canbe derived from it by putting it to its best alternative use.For most resources there will be its alternative use:

1. The resource may be rented out. The opportunity cost isthe rental revenue foregone by undertaking the project.

2. The resource may be sold. Opportunity cost is the value

realized from the sale of the resource after paying thetaxes.

3. The resource may be required elsewhere in the firm. Inthis case the cost of replacing the resource represents it

oppurtunity costs



Costs indirectly related to product/service

General administrative expense

Managerial salaries

Legal expenses

Allocated on basis like labor hours, machine hours or prime costs

When a new project is proposed, a portion of overhed costs isusually allocated to it.

For purpose of investment analysis, what matters is theincremental costs attributed to it and not the allocated overheadcosts



Working capital = [curent assets,loans,advances]-[currentliabilities and provisions]

Current liabilities and provisions are deducted from

current assets because they represent non investor claims.

Another important point is that the requirement of working capital is likely to change over time.

While fixed asset investment are made during the earlyyears of project and depreciated over time,working capitalis renewed periodically, hence is not subject todepreciation.



The cash flow stream relating to long term funds consists of threecomponents as follows:

1. Initial investment

Long term funds invested in the project:Fixed assets + working capital margin

2. Operating cash flowProfit after tax + Depreciation + other non cash charges + interest on long

terrm borrowings(1-tax rate)

3. Terminal cash flowNet salvage value of fixed assets + net recovery of working capital margin

Net cash flow will be calculated as summation of above 3 components

incremental principle

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