Question

How does opportunity cost relate to the notion of incremental cash flow for a project?

Explain and discuss very detail with examples for 3-4 paragraphs.

Answer 1

The cash flows used in project evaluation include all relevant cash flows associated with the investment. These include the initial investment, the opportunity cost of assets, the terminal cash flow, and others.

Answer and Explanation:

1.

Opportunity cost is the benefit foregone as a result of undertaking a project. This opportunity cost may be associated with a particular asset or it may be the cost of an alternative mutually exclusive investment. Thus, even if the company is not using any of its assets in a new project, an opportunity cost may still arise due to the abandonment of another investment.

2.

Incremental cash flows are defined as the cash flows of the company with the project minus the cash flows of the company without the project. Opportunity cost is always an incremental cash flow and is therefore relevant to the project analysis. Here is an example:

Suppose a firm owns a truck that can be used in a project. If the truck is not used, it will be sold for $10,000. The incremental cash flow is the project cash flow minus the price of the truck:

• Incremental cash flow = Cash flow of firm with project - Cash flow of firm without project = Project cash flows -$10,000.

The incremental cash flow of the project is reduced by $10,000 because the truck can be sold if the project is not accepted. The opportunity cost of the truck is -$10,000. It is incremental because this cost results from undertaking the project.