1. What do we mean by \"Relevant Cash Flows\" of a project? And why we should ap
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Question
1. What do we mean by "Relevant Cash Flows" of a project? And why we should apply "stand-alone principle" in making capital investment decisions? (10 points out of 100) In 2015, BonTerra Resources Inc. had sales of 7.5 million dollars, costs of 3.2 million dollars, depreciation of $950000, and a 30% tax rate. What is the operating cash flow of BonTerra in 2015? (10 points out of 100) 3. BonTerra Resources Inc. wants to purchase a new tunnel boringachie (TBM). There are three options, with the following information The discount rate is 12%. (20 points out of 100) OptionsUseful Life (vears) TBM A TBM B TBM C Initial Cost 1.2 million dollars 4.0 million dollars 1.9 million dollars Annual Maintenance Cost $60,000 $80,000 $70,000 Salvage Value $200,000 $500,000 $300,000 a) b) Using EAC criteria, which one BonTerra should buy? If BonTerra needs the TBM machine for 6 years, what is the best purchasing policy? (Note that, a TBM machine should be replaced with new one after its useful life.) 4. What is the "Average Accounting Return" of following investment?(10 points out of 100) Life: 4 years Required capital: $150500 Before tax annual cash inflow: $35500 Tax Rate: 30% Depreciation method: straight-lineExplanation / Answer
1. In the context of a project relevant cash flows are those cash inflows and outflows whose inclusion or exclusion will have an effect on the overall investment decision. There are various cash outflows that have already occurred. For example outflows like research and development (R&D), preliminary research costs regarding the market potential and market feasibility, etc. have already been committed and hence such costs should not be included when analyzing a project for the purpose of capital budgeting and investment analysis. These types of costs, therefore, will not be considered as relevant costs. Depreciation is a non cash expenses and is an accounting concept. It is also not considered as a relevant cost as it does not affect the analysis of a project.
Thus for a project, relevant costs are usually incremental cash flows that are calculated on an after tax basis. Incremental cash flows are the difference between future cash flows with the project and future cash flows if there is no project. Costs that are relevant are opportunity costs, changes in net working capital, etc.
Thus, in most simple terms, relevant cash flows are those flows that will occur only in the case if the project is accepted.
"Stand alone principle" should be applied as it helps in evaluating and analyzing each and every project in isolation from the organization to which the project relates to. This is important as it helps in the evaluation of a project only on the basis of its incremental cash flows. This principle recognizes the fact that each project has its own cash flows and own revenues and costs. This will allow the finance managers to evaluate a project on its own merits only.
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