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It is related to cash flow forecasting and liquidity estimation made for a new project. Positive incremental cash flow (ICF) related to a new project shows the project is worth investing, and if the value is negative, then the project may not be that beneficial.
ICF = Revenues – Expenses – Initial Cost
If a firm designs two new products and is looking to compare, it will evaluate the revenues generated and the initial cash outlay.
If the overall expenditure is higher for one of the products, while, the ICF is the same for both, the one with lower expenses will be preferred.
The main advantages of the method are that it helps businesses to decide whether to invest in some assets or not or get the data for commodity swap valuation in conditions if they plan to look to expand on their existing product line or increase in a new product based on it.
The limitations of the method are that there are multiple variables used to evaluate a project, which cannot be analyzed at the start.
Further, the regulatory aspects and market conditions may change with time and the project may suffer losses due to such unforeseen factors.
One such example is the acquisition of Corus Group by the Tata steel group.
Tata invested as it provided a way to tap and infiltrate the European Markets, and the ICF calculations showed benefits out of acquisition but internal and external factors resulted in a slump in steel demand and the firm was forced to shut down the plant in Europe and later, they planned to sell some of the acquired units.
With every new business, the expense increases with time and this can strain the budget of a company. So such decisions should be monitored carefully to get an accurate estimation of income and financial performance.
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