Question

4. The impact of indirect effects of a capital budgeting project should be included in cash flow estimation. Give some examples of indirect effects, and explain why they are important and should be considered in the capital budgeting decision process.

Answer 1

Capital budgeting refers to the identification ,evaluation, implementation and subsequent monitoring of long term projects.In capital budgeting the indirect costs refer to costs that may affect the profits of the other business activities.An example of the indirect effects that are factored into the cash flow estimation is cannibalization.Cannibalization refers to the reduction or displacement in sales of a product that already exists by a product that was just launched.An eg: Assume a firm is in the business of manufacturing and selling a car ,the launch of a new car model might impact the sales of the old model.This reduction in sales is referred to as cannibalization and to understand the impact they are factored into the incremental earnings.Another example of indirect effects is the change in working capital.That is the increase in inventory required in association with a new project increase in receivable in connection with the new project etc.This increase in working capital is factored into the cash flows if it happens during the initial year(year of outflow) or if it occurs during the life of the project,and it's recovery in the final year.