In this post I want to point out some important characteristics of incremental free cash flows in a discounted cash flow (DCF) analysis. Incremental cash flows after taxes are the basis of each DCF analysis and in this way of each investment valuation.
Relative View to Alternative Scenario
Incremental means that the cash flows are caused by a positive investment decision. Positive decision means that the investment project is decided to be realized. Incremental cash flows are the cash flows that are additional to the cash flows of a negative investment decision (zero scenario or better alternative scenario). But to get the additional cash flows to the alternative scenario, you have to know the alternative scenario! In many cases, especially in “green field” projects, it is easy. There are simply no cash flows concerning your company in the alternative scenario. But it can become more complicated, if the alternative scenario depends on other investment project decisions that are not decided yet. In this case the investment projects are interrelated. Investments projects can for example require the same investment resources. But the company has to purchase it only once. If resources are used by several investment projects, the investment planning and DCF calculation must be done in a comprehensive company view. Only in this way you can allocate the investments to the investment projects. But nevertheless this is not always clear, because this allocation to a certain project can be ambiguous. Many companies have a central investment planning department which ensures that interrelated investment projects are harmonized.
A company can have the choice between two exclusive scenarios, which are both unprofitable stand-alone. But the company has to choose on of these two alternatives. When making a DCF analysis of one of these scenarios you have to take into account that the other scenario is not zero cash flow but the second excluding alternative scenario. That can lead to the fact that the DCF analysis becomes profitable because the negative effects of the alternative scenario can be prevented. Can that be true? Yes, because a DCF analysis is always decision focused and the decision can be more profitable than the realization of the alternative scenario. It is very important to have in mind this relative characteristic of a DCF analysis.
Sunk Costs and Opportunity Costs
An additional crucial point is that the incremental free cash flows must be caused by the decision to realize an investment project (principle of cause and effect). Costs that are linked to the project but cannot be influenced by the investment decision itself are so called sunk costs. Sunk costs are not part of the incremental free cash flows. In this way your DCF calculation shows whether the decision to realize the investment project is profitable for the company or not. But generally it does not show whether the project itself is profitable or not. Management cannot avoid sunk costs, hence the calculation show straightforward the ability to influence the future development. But you also have to take into account opportunity costs. These are negative cash flows effects caused by the investment decision but actually part of other projects. For example, the launch of a new product can substitute the volume of another (just released) investment project. Another example is a price reduction on the product which volume is part of the contribution cash flows of another investment project. This relationship also has to be considered if you are doing a recalculation of an investment project.
You should always consider these two point in a DCF analysis: 1) The relative view compared to the alternative scenario and 2) the decision making focus ignoring sunk costs and including opportunity costs. Sometimes companies are making recalculations of their investment projects. Recalculations can only be compared with the original, decision focused DCF analysis when taking the same assumptions. In an interrelated investment world you cannot recalculate one investment project without knowing the relationship to the other investment projects.