1. Identifying incremental cash flows When firms make capital budgeting decision

Question

1. Identifying incremental cash flows When firms make capital budgeting decisions, they should concern themselves with incremental cash flows, not net income, when evaluating projects. Indirect cash flows often affect a firm?s capital budgeting decisions. However, some of these indirect cash flows are relevant to capital budgeting decisions (because they represent marginal cash flows that depend on the project?s acceptance), but others should be ignored. are cash flows that the firm forgoes as a result of accepting the project under consideration. In general, these are cash flows of the next best alternative to the project. Consider the case of Bumbly Products Inc. The company is evaluating a capital budgeting project and has come across a few issues that require special attention. Classify each item as a sunk cost, cannibalization, opportunity cost, or a change in net working capital (NWC). Then, in the last column, indicate whether the item should be included in the project?s analysis or not. Suppose Bumbly will be issuing debt to support this project and other capital budgeting projects this year. The firm?s interest expense will increase by $700,000. Should the change in interest expense be included in the analysis? Yes No

Explanation / Answer

Reduce sale revenue of other project Cannibalisation Include in Analysis Existing equipment which can be sold( It should be classified as sunk cost if the company will not sell it and is irrelevant in analysis. If the company wishes to sell if the project is not undertaken then it is oppurtunity cost) Oppurtunity cost Include in Analysis Expenditure on Market research Sunk Cost Not include in Analysis Credit sales resulting In increase in accounts receivable Change in NWC include in Analysis Alternative use of factory resulting in positive NPV Oppurtunity cost Include in Analysis Increase in interest expense by 700,000 will be included in analysis

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