Introductory Corporate Finance: Cash Flow Estimation - Incremental Cash, Flows Sunk Costs Opportunity Costs Externalities Cannibalization Complementarity Side Effects

What This Is

Incremental cash flows are the changes in cash inflows or outflows resulting from a specific decision or action. In corporate finance, understanding incremental cash flows is crucial for evaluating investment opportunities, assessing project viability, and making informed decisions about capital budgeting. For instance, consider a company like Tesla, which is considering investing in a new electric vehicle model. The incremental cash flows from this investment would include the additional revenue from sales, minus the additional costs of production, marketing, and research and development.

Key Formulas & Models

• Incremental Cash Flow (ICF) = (Revenues - Variable Costs) - (Fixed Costs - Depreciation): This formula calculates the incremental cash flow from a specific decision or action. Revenues and variable costs are the changes in cash inflows and outflows directly related to the decision. Fixed costs and depreciation are the changes in cash outflows that are not directly related to the decision.
• Opportunity Cost = (Expected Return on Alternative Investment) x (Investment Amount): Opportunity cost is the value of the next best alternative investment that is given up when making a decision. It is calculated by multiplying the expected return on the alternative investment by the investment amount.
• Sunk Cost = (Initial Investment) x (Salvage Value): Sunk cost is the initial investment that is not recoverable, even if the project is abandoned. It is calculated by multiplying the initial investment by the salvage value.
• Externalities = (Cannibalization Effect) + (Complementarity Effect): Externalities are the indirect effects of a decision on other projects or investments. Cannibalization effect is the reduction in sales or revenue from existing products or services due to the introduction of a new product or service. Complementarity effect is the increase in sales or revenue from existing products or services due to the introduction of a new product or service.
• Side Effects = (Positive Side Effects) + (Negative Side Effects): Side effects are the indirect consequences of a decision that are not directly related to the decision. Positive side effects are the benefits that are not directly related to the decision, while negative side effects are the costs that are not directly related to the decision.
• Net Present Value (NPV) = ?(CFt / (1 + r)^t): NPV is a measure of the present value of a project's cash flows. It is calculated by discounting the cash flows at the risk-free rate and summing them up.
• Internal Rate of Return (IRR) = r: IRR is the rate at which the NPV of a project's cash flows equals zero. It is the rate at which the project's cash flows are equal to the initial investment.

Step-by-Step Calculation

1. Identify the incremental cash flows from the decision or action.
2. Calculate the opportunity cost of the decision or action.
3. Calculate the sunk cost of the decision or action.
4. Calculate the externalities of the decision or action, including cannibalization and complementarity effects.
5. Calculate the side effects of the decision or action, including positive and negative side effects.
6. Calculate the NPV of the project's cash flows using the IRR as the discount rate.

Common Mistakes

• Mistake: Ignoring sunk costs when evaluating a project's viability.
• Correction: Sunk costs should not be considered when evaluating a project's viability, as they are not recoverable.
• Mistake: Failing to consider opportunity costs when evaluating a project's viability.
• Correction: Opportunity costs should be considered when evaluating a project's viability, as they represent the value of the next best alternative investment.
• Mistake: Confusing cannibalization effect with complementarity effect.
• Correction: Cannibalization effect is the reduction in sales or revenue from existing products or services due to the introduction of a new product or service, while complementarity effect is the increase in sales or revenue from existing products or services due to the introduction of a new product or service.

Exam / CFA Tips

• Tip: When evaluating a project's viability, consider both the incremental cash flows and the opportunity costs.
• Tip: When calculating NPV, use the IRR as the discount rate.
• Tip: When evaluating externalities, consider both cannibalization and complementarity effects.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, tax 25% - compute DFL (Degree of Financial Leverage).

Answer: DFL = (EBIT / (EBIT - Interest)) = (10 / (10 - 2)) = 2.5

Explanation: DFL measures the sensitivity of EBIT to changes in sales.

Last-Minute Cram Sheet

• Incremental cash flow: The change in cash inflows or outflows resulting from a specific decision or action.
• Opportunity cost: The value of the next best alternative investment that is given up when making a decision.
• Sunk cost: The initial investment that is not recoverable, even if the project is abandoned.
• Externalities: The indirect effects of a decision on other projects or investments.
• Side effects: The indirect consequences of a decision that are not directly related to the decision.
• NPV: A measure of the present value of a project's cash flows.
• IRR: The rate at which the NPV of a project's cash flows equals zero.
• Cannibalization effect: The reduction in sales or revenue from existing products or services due to the introduction of a new product or service.
• Complementarity effect: The increase in sales or revenue from existing products or services due to the introduction of a new product or service.
• DFL: A measure of the sensitivity of EBIT to changes in sales.
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.