If the advertising is in both the papers and on the radio, then the incremental revenue will be 45% x $40,000 = $18,000. Thus if the advertising is only in the papers, then the incremental revenue earned will be 40% x $40,000 = $16,000. 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. It is not dependent on the decision being made. 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.
The existing revenue of $40,000 is not incremental. 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%. Revenue from the existing business is $40,000 per year. The cash flow does not arise because of the decision being made it arises anyway and is therefore not a relevant cash flow.Ī further example of the incremental concept relates to revenue. 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. 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. 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. Mrs Clip will carry on with this advertising…’. 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. Please read the question before continuing. 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. These definitions sound easy, and candidates often do well when relevant cash flows are examined in a written format. 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. While not specifically included in the definition of a relevant cash flow (as noted above) opportunity costs are also relevant cash flows. 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. Anything that has occurred in the past is referred to as a sunk cost and should be excluded from relevant cash flows. Accordingly, for example, depreciation charges should be excluded.Īny relevant cash flow should arise in the future. While on the face of it obvious, only costs or revenues that give rise to a cash flow should be included. 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.Ī definition often used for relevant cash flows states that they must be cash flows that occur in the future and are incremental. 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. Relevant cash flows can be examined in either a written or calculation format. 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.
CASH FLOW FINANCE DEFINITION PROFESSIONAL
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