Question

What is a side effect? How is it treated in capital budgeting analysis? Give an example. What are you trying to achieve when you deal with side effects in your analysis?

Answer 1

Capital budgeting is choosing between capital projects , based on their future (strictly incremental)cash inflows & outflows ,also depending on the amount of investible cash funds available at present---that necessitate the analysis of choices for decision-making --so as to decide on the ones that will add value to the firm & eliminate or leave out the rest.

On the way to analysing the cash flows as above, there are some side-effects --ie. Some additional costs or benefits that affect the firm's decision-making process.

For example, the firm may want to use the land to build a project, which, if the project is not opted for, is likely to fetch rent revenues (for say, $ 75 Month)by letting out, then this cash inflow is to be treated as opportunity cost, ie. Cash value of the rental opportunity lost (is to be treated as cash outflow for the current one).

On the benefits side, promoting the sale of the new product may also simultaneously increase the sale of some of its old products ,already in the market--- exclusively as a result of taking up this capital expenditure.Say ,sale of jam(old product) is increased/doubled due to introduction of bread (new product) --- after incurring heavy one-time advertising & promotion expenditure.

These side-effects are to be considered while analysing a capital investment decision for the following reasons:

1.decides the rate of return from the project--which in turn needs to be compared with the cost of borrowing the relevant funds or the cost of its internal capital.

2.increase/decrease the future cash flows that affect the entire scenario of the company's cash poition

3.decide the quantum of value-creation to the owners/shareholders ,

Only then, the company will get a true , comprehensive   & an all-inclusive picture--to decide on the right lines.