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Financial Management Incremented Cash Essay

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Updated: Jan 10th, 2022

Introduction

The initiation of the new project by a manufacturer will be closely associated with the necessity to consider the incremental costs, as well as the payback period that will be needed for covering the expenses for the project initiation. Since the actual importance of the incremented cash flow is explained by the necessity to control expenses and incomes, the paper aims to calculate the cash flow, as well as payback period, and net present value.

Incremental Cash Flow

The initial data associated with the project start are based on the company’s expenses and incomes. Therefore, the company anticipates gaining up to $950,000 of yearly sales for the first year. The following years’ sales are forecasted to increase this level to $1,500,000. Direct costs of the project involve 55% of the sales incomes, and these are mainly labor and materials. Indirect costs are $80,000 a year. A new plant is required for the project that will cost $1,000,000. The company’s marginal tax rate is 35%.

The incremental costs were calculated by the presented costs and values. Hence, the costs that were considered are the incremental costs, costs for plant building, as well as direct costs that will be $ 522 500 for the first year, and $ 825 000 for the following years. (Barr, 2002)

Hence, the costs were compared with the sales level

year 1 year 2 year 3
Sales $ 950 000.00 $ 1 500 000.00 $ 1 500 000.00
Direct costst $ 522 500.00 $ 825 000.00 $ 825 000.00
Indirect costs $ 80 000.00 $ 80 000.00 $ 80 000.00
New plant cost $ 1 000 000.00 $ 0.00 $ 0.00
Incremental costs -$ 652 500.00 $ 595 000.00 $ 595 000.00

The payback period will be 3 years. The first year will be featured with essential losses, while the stable income is forecasted for the following years.

Project Discussion

The project itself is quite effective, and, following the financial data offered in the project description, as well as financial management analysis, it is quite costly. Because the first year after the project implementation will be featured with the essential losses, the following years will bring sufficient income if the forecasted sales levels reach the necessary level. The project analysis from the perspective of the effectiveness of the financial management will be performed following the principle stated by McMenamin (2008, p. 45):

Using a related technique, analysts also run scenario-based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, “global” factors, as well as for company-specific factors. As an example, the analyst may specify various revenue growth scenarios, where all key inputs are adjusted to be consistent with the growth assumptions, and calculate the NPV for each. Note that for scenario-based analysis, the various combinations of inputs must be internally consistent, whereas for the sensitivity approach these need not be so.

In the light of this statement, the effectiveness of the project, as well as the reliability of the financial management principles discussed will have to be considered regarding the global factors. Therefore, if the company’s decisions were made by the policy of not accepting projects that require more than three years, the decision of accepting this project would be rather risky. On the other hand, if the company had a guaranteed opportunity of reaching the forecasted sales level, the risks would be minimized. Hence, unbiased NPV should be considered, while management principles will have to be based on the subjective probability of the project development scenario. (Khim, et.al., 2002)

If the project required additional investment, this would seriously affect the decision. Therefore, the project requires sufficient investment, and it is featured with high direct and indirect costs. If additional investments are needed, the risk of the project will be increased essentially. Everything would depend on the project life. Hence, the revenues will not be able to cover the expenses and generate sufficient incremental cash flow for covering the costs. However, because incremental costs of the initial project are quite stable, the additional investment would just increase the payback period. Hence, the project should be accepted and developed. Assuming that the project will develop further, the financial parameters will be as follows

Year 4 Year 5 Year 6 Total
Sales $ 1 500 000.00 $ 1 500 000.00 $ 1 500 000.00 $ 8 450 000.00
Direct costst $ 825 000.00 $ 825 000.00 $ 825 000.00 $ 4 647 500.00
Indirect costs $ 80 000.00 $ 80 000.00 $ 80 000.00 $ 480 000.00
New plant cost $ 0.00 $ 0.00 $ 0.00 $ 1 000 000.00
Incremental costs $ 595 000.00 $ 595 000.00 $ 595 000.00 $ 2 322 500.00

Hence, the project is quite reliable and should be accepted. Regardless of the high initial costs, the forecasted revenues will create sufficient incremental cash flow.

Reference List

Barr, M. J. (2002). The Jossey-Bass Academic Administrator’s Guide to Budgets and Financial Management. San Francisco: Jossey-Bass.

Khim, E. M., & Kok Liang, D. L. (2002). The Use of Derivative Financial Instruments in Company Financial Risk Management. Singapore Management Review, 19(2), 17.

McMenamin, J. (2008). Financial Management: An Introduction. London: Routledge.

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