Incremental and Relevant Cash Flows
A valuation should count only the cash flows that change because of the decision. These are the incremental or relevant cash flows, the net difference between the world with the project and the world without it. They include direct effects such as new revenue, and indirect side effects such as cannibalization, where a new product steals sales from the firm’s own existing lines. The rule is a subtraction. With minus without. Anything that happens either way is irrelevant and must be left out, which is why these cash flows are measured on a cash basis rather than from a standalone accounting statement.
Why it matters
Imagine the firm photographs its future twice, once if it accepts the project and once if it walks away. The valuation cares only about the gap between those two pictures. New sales count. So does the dent the new product puts in an old one, because that lost margin would have existed without the project. A cost the firm pays no matter what does not count. The discipline is to ask of every dollar, would this cash flow be different if we said no. If not, ignore it.
Formulas
Worked examples
A coffee chain opens a new store. It expects US$200 of new revenue, US$80 of rent and operating cost, and US$60 of new staff cost. A nearby existing store loses US$20 of revenue to the new one. What is the net incremental cash flow?
Take new revenue of US$200, subtract the new costs of US$80 plus US$60, which is US$140, then subtract the US$20 of cannibalized revenue from the old store. The net incremental cash flow is 200 minus 140 minus 20, which is US$40. The US$20 lost at the old store is genuinely relevant, because that revenue would still exist if the firm chose not to open the new outlet. Counting only the new store’s own figures would overstate the project by US$20.
Common mistakes
- ✗Every cash flow the new project touches is relevant. Only the cash flows that change with the decision are relevant. Flows that occur with or without the project must be excluded.
- ✗Cannibalization can be ignored because the sales stay inside the company. Cannibalized sales are a real cost of the project, since that margin would have survived had the project not gone ahead.
- ✗Relevant cash flows are read straight off the income statement. Accounting statements mix in allocated and non-cash items. Incremental analysis isolates only the cash that the specific decision changes.
- ✗Indirect effects are too small to matter. Side effects such as lost sales on a related product can flip a project from positive to negative, so they belong in the analysis from the start.
Revision bullets
- •Count only cash flows that change with the decision, with minus without
- •Direct effects: new revenue and new costs the project creates
- •Indirect effects: cannibalization of the firm’s own existing sales
- •Cannibalized margin is a real cost of going ahead
- •Anything that happens either way is irrelevant and is excluded
- •Measure on a cash basis, not from a standalone accounting statement
Quick check
A firm launches a new product that takes some sales from its existing product. In the valuation, the lost sales on the existing product are
Connected topics
Sources
- Titman & Martin, Ch. 2Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.Defines relevant and incremental cash flows, including direct effects and cannibalization side effects.