Reading: Incremental Net Cash Flows

Very often, the launch of a new product or project affects the revenues and costs of existing products and activities. The effect can go both ways:

• Positive synergies: The investment decision has positive financial effects on other firm activities, for example because it creates additional sales for these activities or it reduces costs.
   
• Negative synergies: The investment decision has negative financial effect on other firm activities, for example because it lowers the sales of existing products or triggers additional costs.

To the extent that these (positive or negative) synergies are triggered by the investment decision under consideration, we have to reflect them when estimating the incremental cash flows: Positive synergies increase the project's incremental cash flows and therefore boost project value. In contrast, negative synergies lower the incremental cash flows and reduce project value.

Example

Super Drill Company is considering launching a new drilling machine for orthopedic surgery:

• The company expects to sell 1'000 such machines per year over the next 2 years at a price of $5'000 each. Costs of goods sold are $2'500 per machine and the tax rate is 20%.
   
• There is no initial investment required and there are no additional working capital needs due to the project.
   
• However, the new drilling machine will replace the current model, which was expected to sell 800 units at a price of $4'000 each and a production cost of $2'500 apiece. 
   
• Based on this information, what are the incremental net cash flows of the new drilling machine?

The following table details the analysis: 
  

Discussion:

• Annual revenues of the new machine are $5 million (=1'000×5'000). However, the launch of the new machine reduces expected revenues of the old machine by $3.2 million (= 800×4'000). This loss in sales is the result of the decision to launch the new machine, hence we have to reflect it in our computation of the incremental net cash flows: The incremental revenues of the new machine are only 1.8 million (5 - 3.2).
   
• Costs: Similarly, by launching the new machine, the company saves production costs of the old machine, namely $2 million per year (= 800×2'500). Consequently, the incremental costs are only 0.5 million, not the full production costs of the new machine of 2.5 million (=1'000×2'500). 
   
• EBIT: With this information, we can compute the incremental annual EBIT of 1.8 - 0.5 = 1.3 million.
   
• The remainder of the cash flow statement then follows the procedure from the preceding section. Since there are no changes in the NWC and no new investments, according to our assumptions, the statement is fairly simple.
   
• Taken together, the analyses imply an annual incremental net cash flow of 1.04 million for the new machine. 

In reality, it is often difficult to assess synergies (both positive and negative). The reason is that we cannot observe what would have happened had we not taken a specific investment decision. Also, the world is often more complex than one simple project interaction.

For example, in the case of Super Drill Company considered above, it could be that competitors are also working on a new machine. If so, one could argue that a new drilling machine will be introduced regardless of whether Super Drill Company launches it or not. Consequently, the loss in revenues (and costs) of the old machine would no longer be caused by Super Drill's decision about the new machine! We should therefore ignore them when valuing the new machine.