Question

12-1 Operating cash flows rather than accounting income are listed. Why do we focus on cash flows as opposed to net income in capital budgeting?

12-2 Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included. Give an example of each.

12-3 Explain why net operating working capital is included in a capital budgeting analysis and how it is recovered at the end of a project’s life.

12-4 Why are interest charges not deducted when a project’s cash flows for use in a capital budgeting analysis are calculated?

Answer 1

12-1)

We focus on operating cash flow and not net income because net income is calculated by subtracting the non-cash flow item while the operating cash flow removes the effect of non-cash flow item like depreciation. While analyzing a project the initial outflow is treated as an expenditure so adding non-cash expenditure like depreciation makes it appropriate to evaluate the project viability because there is no actual cash outflow happening with depreciation being subtracted but it acts as a tax break.

12-2)

Sunk cost are cost which have occurred in the past and cannot be undone whether a new project will be taken or not where as opportunity cost is next best alternative which would have been selected if not the current one. Let’s say an inventory house was build a year ago but is not being used currently, that is an example of sunk cost but suppose instead of using it we can give it to rent and earn rental income, here rental income is an opportunity cost.

12-3)

Net operating capital is an investment so it is considered while evaluating the project and it is treated as an outflow but it actually the difference between the operating asset and operating liabilities so it is recovered at the end, at the end of the project it is treated as an cash inflow for the project.

12-4)

Interest charges are not deducted while evaluating the project because interest cost is implicit in the cost of debt which is the required rate that is used in calculation of WACC and WACC is used to evaluate the project, subtracting the interest cost would be misleading because we are considering it two times, one in income statement and another in WACC.