INCREMENTAL CASH FLOWS

Reference E3 (d) of the FFM study guide requires candidates to be able identify/evaluate relevant
cash flows for investment decisions. The identification of relevant cash flows is also examined in
higher level papers.

DEFINITION
A definition often used for relevant cash flows states that they must be cash flows that occur in the
future and are incremental.

Cash flow
While on the face of it obvious, only costs and revenues that give rise to a cash flow should be
included, so for example, depreciation charges should be excluded.

Future
Any relevant cash flow should arise in the future. Anything that has occurred in the past is referred to
as a sunk cost and should be excluded from relevant cash flows.

Incremental
Only cash flows that arise because of the decision being made should be included; any cash flow that
would have arisen anyway, sometimes referred to as a committed cost, should be excluded.
Candidates can often struggle to pick up the incremental cash flows within a question, and it is this
element of the definition that this article will concentrate on.

Example
Let us consider an easy example:
Zob Co is considering investing in a new project to produce the Elfin.
The machine required to produce the Elfin will cost $400,000 which is payable immediately. It will
have a life of four years, at the end of which the scrap value will be $5,000.
The following budgeted information is available:
 1,500 units will be sold each year for $125 per unit, giving rise to revenue per year of $187,500.
 Variable costs per unit will be $21, giving rise to a total variable cost of $31,500 per year.
 Rent and rates of $1,200 will be allocated to the new product each year.

What are the incremental cash flows associated with this project?
Incremental cash flows
So we are looking for the incremental cash flows for the project – ie those cash flows that will arise
because the project is being taken on.

In this case, the initial investment of $400,000 and the scrap value of $5,000 are both incremental
cash flows as they only arise if the project is taken on and the Elfin made. The initial investment is an
outflow, the scrap value is an inflow.

Similarly, the revenue of $187,500 per year and the variable costs of $31,500 per year are also
incremental cash flows. These cash flows will only arise if the Elfin is made and sold. The revenue is
an inflow, the variable costs are an outflow.

However, the rent and rates are not incremental to the project. These costs have been allocated to
the project. The company, Zob Co, will have to pay the rent and rates whether or not the Elfin is
made, and therefore they are not incremental cash flows.
 Example extension
Candidates often cope better with the more straightforward scenarios as we have above, but what if
the scenario is more complicated?
Using the same example as before, but adding some extra information (shown in bold):
Zob Co is considering investing a new project to produce the Elfin.
The machine required to produce the Elfin will cost $400,000 which is payable immediately. It will
have a life of four years, at the end of which the scrap value will be $5,000.
The following budgeted information is available:
 1,500 units will be sold each year for $125 per unit, giving rise to revenue per year of $187,500.
 Variable costs per unit will be $21, giving rise to a total variable cost of $31,500 per year.
 Rent and rates of $1,200 will be allocated to the new product each year.

During the installation of the new machine, Zob Co could pay $20,000 for a modification to be
made which would increase the efficiency of the machine. The modified machine would have a
scrap value of $6,000 in four years time. The modification would allow the annual output to
increase to 1,650 units, and the variable costs per unit to reduce by 5% across all production.
All the increased output can be sold.
What are the incremental cash flows arising from the modification?

Incremental cash flows

The requirement here is not for the incremental cash flows of the project, but the incremental cash
flows arising from the modification. We are looking for those cash flows that will arise if the
modification is completed. The question to ask ourselves every time is 'what is the extra cash flow that
will arise if modification takes place?'
In this case, the $400,000 purchase cost is not an incremental cash flow, the cost of $400,000 will be
paid whether or not the modification is completed.

The $20,000 modification cost is an incremental cash outflow as it only has to be paid if the
modification goes ahead.

Looking at the cash flows in relation to the scrap value, if modification does not take place, the cash
flow will be $5,000, but if the modification does take place, the cash flow will be $6,000. So the
incremental cash flow arising for the modification – ie the extra cash flow that will arise if modification
takes place, is the difference of $1,000. This will be a cash inflow, as an extra $1,000 will be received
in scrap value if the modification goes ahead.

Some candidates find the incremental cash flows in a scenario like this easier to calculate if they
follow the proforma:

Cash flow original situation x

Cash flow changed situation y

____

Difference – ie the incremental

cash flow x-y
 Candidates then have to consider if the incremental flow is a cash inflow or a cash outflow.
So in the case of the scrap value:

Cash flow no modification 5,000

Cash flow with modification 6,000

_____

Difference – ie the incremental

cash flow 1,000

Now to consider the signage of the incremental flow. If the modification takes place, Zob Co will
receive an extra $1,000 of income, so the incremental cash flow is an inflow.

Now let us consider the increased output - this will affect both revenue and variable costs.

If the output is increased, the revenue will be increased (we are told that all output can be sold).

The incremental revenue that will arise if the modification is made will be equal to the extra units that
can now be made and sold (150) multiplied by the revenue per unit of $125, giving an incremental
cash flow of $18,750.

Using our proforma:

Cash flow no modification 187,500

Cash flow with modification 1,650 x $125 206,250

_______

Difference – ie the incremental

cash flow 18,750

Considering the signage of the incremental flow, if the modification occurs, then Zob Co will receive
extra revenue, and so the incremental cash flow is an inflow.

Let us now consider variable costs, where there are two different effects of the modification to
consider:
 variable costs will rise because more units are being made
 variable costs per unit will fall because the increased efficiency of the machine. Note we are told
that this fall in variable cost per unit will occur over all of the output.
 In a situation like this, it is often easier to use the proforma:

Cash flow no modification 31,500.00

Cash flow with modification 1,650 x $21 x 0.95 32,917.50

_______

Difference – ie the incremental

cash flow 1,417.50

This incremental flow is an outflow. If the modification goes ahead, Zob Co will have to pay $1,417.50
more in variable costs.

The allocated fixed costs are still not incremental as explained earlier.

So in summary the incremental cash flows for the modification are:

0 1 2 3 4

$ $ $ $ $

Revenue 18,750 18,750 18,750 18,750

Variable
costs (1,417.50) (1,417.50) (1,417.50) (1,417.50)

Investment (20,000)

Scrap 1,000

These cash flows can then be used further to, for example, decide if the modification should take
place, by calculating the net present value of the incremental flows.

CONCLUSION
It is hoped that this article, will help students identify the incremental cash flows that arise due to the
decision being made, and so aid them in their examination preparation.
PAYBACK AND DISCOUNTED PAYBACK
In the Study Guide for Paper FFM, reference E3(a) requires candidates to not only be able to
calculate the payback and discounted payback, but also to be able to discuss the usefulness of
payback as a method of investment appraisal.

Recent Paper FFM exam sittings have shown that candidates are not studying payback in sufficient
depth or breadth to answer exam questions successfully. This article aims to help candidates with
this.

Candidates should note that payback is not only examined within the Paper FFM syllabus, but also
the Paper F9 syllabus.

PAYBACK
Definition
Payback is defined as the length of time it takes the net cash revenue / cash cost savings of a project
to payback the initial investment.
From the definition, it can be seen that only cash flows should be included within the calculation –
specifically, only relevant cash flows should be included within the calculation, so items such as
depreciation should be excluded.

Calculation
Let’s use the following example:
An organisation is considering a project which has an initial investment of $40,000 and is expected to
generate profit after depreciation but before tax of $12,500 each year for eight years. Depreciation will
be on a straight line basis over the life of the project.
The first step is to determine the cash flows from the project. In this case, we are given the profit
figure so need to adjust for depreciation of ($40,000/8 years) $5,000 per year, to give an annual cash
flow of ($12,500 + $5,000) $17,500.

The second step is to calculate the payback period and the easiest way of completing the calculation
is often via a table:

Cumulative
Time Cash flow cash flow

0 (40,000) (40,000)

1 17,500 (22,500)

2 17,500 (5,000)

3 17,500 12,500

It can be seen from the table that the cumulative cash flow becomes positive in year three. If cash
flows arise at the end of the year, the payback period will be three years. If however cash flows arise
during the year, payback will arise during year three, and more precisely (5,000/17,500 x 12) three
months (to the nearest month) through the year, so giving a payback of two years and three months.
In this example, the same net cash inflow arises every year, starting in year one, and so a short cut is
available:
Payback = initial investment / net cash inflow
Payback = (40,000) / 17,500 = 2.29 years

So if the cash flow arises at the end of the year, payback is three years, and if cash flow arises during
the year, the payback is two years and (0.29 x 12) three months (to the nearest month).
As well as ensuring that the cash flows rather than the profits are used within the calculation,
candidates also need to ensure that they consider the timing of the cash flows.

Using the previous example, how would the answer change if the first cash inflow did not arise until
year three?
The cumulative cash flow table would become:

Cumulative
Time Cash flow cash flow

0 (400,000) (40,000)

1 0 (40,000)

2 0 (40,000)

3 17,500 (22,500)

4 17,500 (5,000)

5 17,500 12,500

We can see that the payback period is either five years if cash flows arise at the end of the year or
four years and (5,000/17,500 x 12) three months (to the nearest month) if cash flows arise during the
year.

Usefulness
Payback is often used as a first screening method for an investment – ie the first question that is often
asked with a new project is: ‘When will the initial cost be paid back?’ An organisation may have a
target payback period, with any project taking longer than the target period being rejected.
Payback also provides more focus on the earlier cash flows arising from a project, as these are both
more certain and more important if an organisation has liquidity concerns.
Two other advantages are that payback is easy to calculate and to understand.
There are, however, disadvantages associated with the payback method of investment appraisal:
 Cash flows after the payback period are ignored, therefore the effect of the whole project on the
cash flows of the organisation are not considered.
 A target is required, which can be difficult to set and is arbitrary.
 The increase / decrease in wealth of the investor arising from the project is not considered – the
net present value of the project would need to be calculated to assess the effect on shareholder
wealth, for example.
 The time value of money is not considered.
This last disadvantage will be overcome if the discounted payback is calculated rather than the
payback period.

DISCOUNTED PAYBACK
Definition
The discounted payback is defined as the length of time it takes the discounted net cash revenue/cost
savings of a project to payback the initial investment.

Calculation
The discounted payback calculation takes into account the time value of money by discounting each
cash flow before the cumulative cash flow is calculated, and determines the time at which the net
present value becomes positive.
Let’s use the first example, but expand it by including the fact that the organisation has a cost of
capital of 10%.
Again, the first step would be to ensure that the cash flows are identified, which we have already done
– $17,500 per year.

The second step is to complete the cumulative cash flow table, but now extra columns are required
for the discount factor and the discounted cash flow:

Cumulative
Cash Discounted Discounted discounted
Time flow factor cash flow cash flow

0 (40,000) 1 (40,000) (40,000)

1 17,500 0.909 15,908 (24,092)

2 17,500 0.826 14,455 (9,637)

3 17,500 0.751 13,143 3,506

From the table above, it is evident that the payback period is three years.
Note that an assumption associated with discounting is that the cash flows arise at the end of the
year, so with discounted cash flow calculations, the answer will always be a whole number of years.

Usefulness
The time value of money is considered when using discounted payback, but otherwise the points
made previously regarding the usefulness of payback hold for discounted payback as well.

CONCLUSION
Candidates need to be able to perform the calculations for payback and discounted payback, as well
as understand how useful these measures, as a method of investment appraisal, can be. It is hoped
that this article will help candidates with both of these elements.
THE INTERNAL RATE OF RETURN

Study guide references E3(g), (h) and (i) refer explicitly to the Internal Rate of Return (IRR). Not only
do candidates need to be able to perform the calculation, they need to be able to explain the concept
of IRR, how the IRR can be used for project appraisal, and to consider the merits and problems of this
method of investment appraisal. In short, IRR can be examined in both a written or calculation format,
within either section A or section B of the exam.

When this topic is examined, candidates have historically not performed very well, showing a lack of
understanding of how the calculation works and what the IRR is.

WHAT IS THE IRR?

The IRR can be defined as the discount rate which, when applied to the cash flows of a project,
produces a net present value (NPV) of nil. This discount rate can then be thought of as the forecast
return for the project. If the IRR is greater than a pre-set percentage target, the project is accepted. If
the IRR is less than the target, the project is rejected.

Considering the definition leads us to the calculation. The IRR uses cash flows (not profits) and more
specifically, relevant cash flows for a project. To perform the calculation, we need to take the cash
flows of a project and calculate the discount factor that would produce a NPV of zero.

If the cash flows of a ‘normal’ (cash outflow followed by a series of cash inflows) project are taken and
discounted at different discount rates, it will be possible to plot the following graph:

The discount rates used are on the x-axis, and the NPV ($) is on the y-axis. As you can see, the
graph is a smooth curve, which crosses the x-axis. It is this point that we need to calculate the
discount rate, which has produced a NPV of zero – this is the IRR.
CALCULATION
It would be very time consuming to calculate the NPV of a project for many different discount factors
and then plot the graph and estimate where the graph crosses the x-axis. Instead, there is a short cut
using the formula:

In order to use the formula then, we need to take the cash flows of the project and discount them
twice – once using a discount rate a%, and once using a discount rate b%. If we plot these results on
a graph it would be as follows:

We know that the line joining these two points should be a curve, but the formula approximates the
curve with a straight line and so calculates the point at which a straight line crosses the x-axis and is
therefore the IRR:
The estimation is most accurate if one NPV used in the formula is positive and the other one is
negative.

So if a candidate chooses a discount factor and calculates the NPV of the project which turns out to
be negative, a lower discount rate should be chosen for the next discounting so that there is a
possibility of obtaining a positive NPV. However, within an exam situation, if a candidate ends up with
two positive or two negative NPVs, do not waste time calculating a third. Put the values you have into
the formula and complete the calculation; no marks will be lost.

Let us put some figures in. A project has an immediate cash outflow of $7,000, and then cash inflows
of $4,000 in years 1 and 2.

If we take the cash flows and discount them at 5% and 20%, the following results are gained.

Note that in an exam situation a candidate could choose any discount rate to start with. In choosing
the second discount rate, though, remember what was said above about trying to gain one positive
and one negative NPV.

If these results are substituted into the formula:

Thus, the IRR is estimated to be 9.9%. This is the return that is forecast for the project. If the target
return was 6%, then the project would be accepted; if the target return was 15%, then the project
would be rejected.

As the cash inflows for the project are an annuity, there is actually a short cut that we can take for the
calculation.
Let's set up the cash flows as an annuity:

For the discount factor (r%) to be the IRR, the NPV must be equal to zero. The table must look as
follows:
Looking at the present value column, we can see that (7,000) + 4,000x AF1-2@r% = 0
Rearranging this gives 7,000/4,000 = AF1-2@r%
ie 1.75 = AF1-2@r%

Looking in the annuity tables, the rate with a two-year annuity closest to 1.75 is 9%.
While this answer is slightly different form the first answer gained, this is because we are always
estimating the IRR, and different estimation methods will give slightly different answers. Either method
would gain full marks in an exam context.

WRITTEN ASPECTS
Candidates need to be able to explain the advantages and disadvantages of the IRR method of
project appraisal.

Advantages
 The method takes account of the time value of money, whereas approaches such as payback do
not.
 The method uses cash flows, which are real, rather than profits, which can be
affected/manipulated by different accounting policies.
 The method gives a result that is easy for management to understand and interpret – a
percentage to be compared to a target.

Disadvantages
 The method assumes that the net cash inflows generated through the project life will be
reinvested to earn the same return as the IRR, but this may not be possible in real life.
 The method ignores the relative size of the investments. Consider the following projects, both of
which have an IRR of 8%:

If the decision was made purely on IRR, both projects would be ranked the same, and no decision
could be made. However, looking at the size of the projects, Project 1 is larger and will generate
greater cash flow and therefore profits for the organisation.
 When looking at the graphs earlier, it was stated that we were considering a ‘normal’ project. If
the project has non-conventional cash flows – for example, cash outflow, inflow and then outflow
– it may be possible to calculate two IRRs. This can be shown graphically:
If only IRR 1 was calculated, then the project would be rejected as the target is higher, but if IRR 2
was calculated, the project would be accepted. So when a project has twoIRRs, there is ambiguity as
to whether the project should be accepted or not.

 Problems arise if an organisation is trying to decide between mutually exclusive projects. This is
when an organisation has two or more projects to choose between, and they can only undertake
one. Let's say that we have Project A and Project B. The cash flows for these projects have been
discounted at various discount rates and the following graph drawn:

On an IRR basis, Project B should be chosen as the IRR is higher. But what if the organisation
actually had a cost of capital of x%? We can see that Project A actually has the higher NPV at this
point, and therefore Project A would increase the wealth of the shareholders by a greater amount, and
should be chosen. So, with mutually exclusive projects, the IRR method can result in the wrong
decision being made.

 The method is easily confused with the Accounting Rate of Return (ARR) method of investment
appraisal. In previous sittings, candidates have performed an ARR calculation rather than an
IRR.

CONCLUSION
Candidates need to have a thorough grasp of the concept, the calculations and the advantages and
disadvantages of the Internal Rate of Return. It is hoped that this article will help with these elements.
RELEVANT CASH FLOWS
The Paper FFM Study Guide references E3 c) and E3 d) require candidates to be able to both
discuss the concept of relevant cash flows and identify/evaluate relevant cash flows.

Relevant cash flows can be examined in either a written or calculation format. It is also important that
candidates can identify relevant cash flows in order to be able to use them in the context of
investment appraisals, for example net present value calculations. Finally, relevant cash flows are not
just an important part of the syllabus for Paper FFM as they can also be examined in later studies, for
example Paper F9.

DEFINITION
A definition often used for relevant cash flows states that they must be cash flows that occur in
the future and are incremental.

Cash flow
While on the face of it obvious, only costs or revenues that give rise to a cash flow should be
included. Accordingly, for example, depreciation charges should be excluded.

Future
Any relevant cash flow should arise in the future. Anything that has occurred in the past is referred to
as a sunk cost and should be excluded from relevant cash flows.

Incremental
Only cash flows that arise because of the decision being made should be included; any cash flow that
would have arisen anyway, sometimes referred to as a committed cost, should be excluded.

Opportunity cost
While not specifically included in the definition of a relevant cash flow (as noted above) opportunity
costs are also relevant cash flows. Opportunity costs are the revenues that are lost (or additional
costs that arise) from moving existing resources from their current use and are therefore considered
to be incremental cash flows arising in the future to be taken into account.
These definitions sound easy, and candidates often do well when relevant cash flows are examined in
a written format. However, it is applying these concepts to a scenario and calculating/identifying the
relevant cash flows that can often cause candidates problems, and it is this that I shall now focus on
using excerpts from the question in Appendix 1 as examples where possible. Please read the
question before continuing.

NUMERICAL EXAMPLE
Scenario 1
In the context of whether a business owner will move her business, we are told that ‘Mrs Clip currently
advertises her business in the local newspapers and business directories, at a cost of $1,000 per year
payable in advance. Mrs Clip will carry on with this advertising…’.

Relevant cash flows from scenario 1

On a relevant cash flow basis, we do not need to be concerned with what has been paid in the past,
so the $1,000 per year paid in the past is a sunk cost and can be ignored from relevant cash flows.
What about the $1,000 per year in the future if Mrs Clip continues with the advertising? This would not
be included as a relevant cash flow, because it is not incremental. The $1,000 cash flow is being
suffered now and will continue in the future, whether or not Mrs Clip moves her business to the town
centre premises. The cash flow does not arise because of the decision being made; it arises anyway
and is therefore not a relevant cash flow.
Scenario 2
A further example of the incremental concept relates to revenue. Revenue from the existing business
is $40,000 per year. We are told that if Mrs Clip advertised her move to the town centre premises in
the papers only, then revenue would increase by 40%, but if the move was advertised in both the
papers and on the radio, then revenue would increase by 45% rather than 40%.

Relevant cash flows from scenario 2

The existing revenue of $40,000 is not incremental. This is the level of revenue that has been earned
by the business in the past and will be earned in the future whether or not a move to the town centre
premises is made. It is not dependent on the decision being made. In order to get the relevant cash
flow, what is required is the incremental revenue – ie the extra revenue that will be earned if the move
is made. Thus if the advertising is only in the papers, then the incremental revenue earned will be
40% x $40,000 = $16,000. If the advertising is in both the papers and on the radio, then the
incremental revenue will be 45% x $40,000 = $18,000.

Scenario 3
Within this question, there were no non-cash flows. However, what if we had been told that Mrs Clip
was going to buy salon fittings for $3,000, and these would be depreciated over five years?

Relevant cash flows for scenario 3

The $3,000 paid for the salon fittings would be a relevant cash flow, and incorporated within any
relevant cash flow schedule at the time at which the fittings were purchased. However, depreciation is
not a cash flow and is therefore not a relevant cash flow. As a result, it the annual depreciation charge
should not be included within any relevant cash flow schedule.

Scenario 4
Opportunity costs arise less frequently within questions, but when they do, they can cause candidates
real problems. There are no opportunity costs within the question we have been considering, but let
us look at an example all the same. An opportunity cost arises if a resource is moved from its current
use. So let us say that we have labour that is currently being used in manufacturing process A.
The following figures are available for manufacturing process A:

$ per unit

Sales revenue 25

Materials 10

Labour (2 hours @ $3 per hour) 6

Variable overhead 2

Contribution 7

Labour is now required for manufacturing process B within the same organisation. Each unit within
manufacturing process B uses two hours of labour. No more labour can be hired and so it would have
to be moved from manufacturing process A. What is the relevant cash flow for labour in process B?
Relevant cash flows for scenario 4
Using our definition of a relevant cash flow to be a future, incremental cash flow, we can ignore the
labour cost of $6 as it is not incremental, it will be paid anyway, either within process A or process B.
However, if we move the labour from A to B, the organisation will have to forgo the sales revenue of
$25 per unit, but they will not suffer the material cost of $10 per unit or the variable cost of $2 per unit.
Thus the net effect, the net cost of moving the labour to process B is ($25 – $10 – $2) = $13 per unit.
This $13 is the opportunity cost, the net revenue lost from moving the labour from its current use. You
may see a short cut to this calculation – that of adding together the contribution lost of $7 to the labour
cost of $6. The total again being $13 per unit. Although this seems theoretically incorrect, as the non-
incremental labour cost of $6 is being included, it is just a short cut to the answer.

CONCLUSION
In a Section B question, candidates need to be able to both explain the principles behind relevant
cash flows and be able to identify/calculate such cash flows, possibly for further use within an
investment appraisal calculation. The question in the appendix is the typical example and I would
strongly recommend you work through the question. The answer is provided in Appendix 2. It is
hoped this article will help candidates with these elements.
Written by a member of the Paper FFM examining team

APPENDIX 1: QUESTION
Mrs Clip runs a hairdressing business from her home. Mrs Clip’s business has expanded, with
revenue now reaching $40,000 per year. Mrs Clip is considering moving her business into town centre
premises, and employing another hairdresser, who would cost $6,000 per year.
She has found premises that could be leased for $3,500 per year payable in advance.

Mrs Clip currently advertises her business in the local newspapers and business directories, at a cost
of $1,000 per year payable in advance. Mrs Clip will carry on with this advertising, but she will also
need extensive ‘one off’ advertising to promote the move to the new premises, and the new
hairdresser joining the business. This ‘one off’ advertising in the local newspapers will cost $2,000,
which will be paid immediately. In addition to advertising the move in the local newspapers, Mrs Clip
could advertise the move on the local radio. The cost of this would be $5,000, also payable
immediately.

Mrs Clip believes that having a town centre presence and the associated publicity in the local
newspapers will increase revenue by 40% in the first year and that it would remain at this new
increased level. If Mrs Clip also advertised on the local radio, she believes that revenue would
increase by 45%, rather than 40%, and would again remain at this new increased level.
Overheads, excluding advertising, would increase to a total of $4,000 per year. Overheads currently
charged to the business are $1,500 per year. Direct costs such as shampoo are budgeted at 5% of
revenue.
Assume that all cash flows arise at the year end, unless otherwise stated.
The cost of capital is 10% per annum.

Required:
(a) Assuming that both radio and newspaper advertising is used, calculate, over a five-year
time period, the net present value of the proposed move to the new premises. On the basis of
your calculation, advise Mrs Clip as to whether or not she should move her business into the
new premises.
(11 marks)
(b) Prepare a net present value calculation over a five-year time period, that justifies the
additional spend on radio advertising rather than advertising in newspapers alone.
(5 marks)