Cost-benefit analysis involves comparing the financial results of the different alternatives as well as carrying out “what if” analysis.
The “Incremental or Differential Cash Flow Report” allows you to add and subtract projects to generate the incremental cash flow or to combine projects.
The following example is for a manufacturing firm exploring a plant expansion to increase sales. The two options are:
- Invest $8.2M to increase the production and sales of products A & B
- Invest $12.26M to increase the production and sales of products A & B plus add a new product “Z”
Using the Incremental Cash Flow Report, the cash flow for the $8.2M expansion option is subtracted from the $12.26M expansion cash flow to generate the incremental cash flow.
The return (IRR) on the additional investment of $4,060,000 for the $12.26M expansion is 3.42%. Clearly the $8.2M expansion is the best option from a financial perspective.
Small business considerations
To stay competitive in their respective industries and maximize potential profits, small businesses often take on new projects. The amount of additional operating cash flow that a company has at its disposal as a result of taking on a new project is commonly referred to as the differential cash flow, or incremental cash flow.
Positive and Negative
Whether a company decides to take on a project usually depends on the value of the project’s anticipated differential cash flow. A positive differential cash flow tells a company that a project will generate an increase in cash flow, whereas, a negative differential cash flow will result in a decline in operating income. To determine the value of differential cash flow, the company must consider the initial outlay, the cash flow from taking on the project and the terminal value, or net cash flow from ending the project.
When determining the net initial investment outlay of a differential cash flow, several financial considerations must be included. Among these are the amount of cash expenditure that the company must make to take on and complete the project, as well as changes in net working capital due to the project. The amount of net cash flow resulting from the sale of existing or nonuseful equipment and from any applicable tax credits should also be included in the net initial investment outlay.
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