Question

Why do we care about incremental cash flows at the firm level when we evaluate a project? Explain why the announcement of a new investment is usually accompanied by a change in the firm’s stock price.

Answer 1

While evaluating new projects, company would require to make decision on whether to invest or not in the new project. This would require companies to analyze the relevant cost and revenue from the project. Incremental cash flows are relevant cash flows which are considered to calculate either net present value, internal rate of return in order to determine whether company should invest. Cash flow which are same as current cash flow is not relevant for decision making as this the firm is already earning and would not impact the decision. Thus, incremental cash flow are considered to evaluate the project.

Announcement of new investment and when the investment in profitable would generally increase the price of product. This is because with new profitable investment company would be able to provide higher return on investment to its shareholders. Thus with expected future growth in company, share price of company tend to change.