Differential cash flow method

Differential cash flow method – 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 basic of Differential Cash Flows – Over the Project’s Life:

   Change in revenue Differential cash flow method

– Change in operating expenses Differential cash flow method

= Change in operating income before taxes

– Change in taxes Differential cash flow method

= Change in operating income after taxes

+ Change in depreciation Differential cash flow method

= Differential cash flow

The following example is for a manufacturing firm exploring a plant expansion to increase sales. The two options are:

  1. Invest $8.2M to increase the production and sales of products A & B
  2. 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.

Differential cash flow method

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.

Initial Outlay

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.

Cash Flow

Companies rely on operating cash flow to maintain their day-to-day operations. When considering a new company project, a business must evaluate the net operating cash flow, another form of differential cash flow. The net operating cash flow is equal to the value of company revenue less expenses and tax liability for a specific time period. When assessing a project, the time frame used should overlap with the projected time frame of the project.

Terminal Value

The terminal value of a project is another key type of an incremental cash flow that must be evaluated when reviewing project feasibility. Also referred to as the net salvage value, this differential cash flow includes the after-tax net cash flow from the termination, liquidation or sale of the proposed project. Such a scenario may occur if the project becomes financially unsustainable. The net salvage value includes the cost for selling assets associated with the project, cleanup and removal and the release of any net working capital.

Differential cash flow method

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