Question

1. How do we determine if cash flows are relevant to the capital budgeting decision?

2. What are the different methods for computing operating cash flow and when are they important?

3. How should cash flow and discount rates be matched when inflation is present?

4. What is the equivalent annual cost and when should it be used?

Answer 1

1.) When doing capital budgeting analysis sunk cost are not considered. Sunk cost are those cost that have been occurred in the past and whether the project is being taken or not the sunk cost is not affected by that. Normally the rule for consideration of any project all the cash flows which are going to be occurred if the project is taken up should be considered in the decision-making process and other cost should be ignored.

2.) There are basically two broad methods of calculating operating cash flow, one is direct method and the other is indirect method.

Direct method: Direct method of calculation of operating cash flow is used when you are considering each of the cash disbursements and cash receipts. This method is useful when the disbursements are happening on cash basis.

Indirect Method: Indirect method is used when disbursements are not happening on complete cash basis and we calculate the operating cash flow by starting from net income and making adjustments for working capital, capital expenditure and depreciation. This method is used mostly because disbursement usually does not happen on fully cash basis.

3.) When inflation is present then we should either adjust the discount rates or adjust the     cash flow. When we trying to discount the cash flows then we are using real discount rates then we should also adjust the cash flows for inflation and when the rates being used are nominal then the cash flow need not be discounted for inflation, since the nominal rate will have already adjusted for that.

4.) Equivalent annual cost is the annual cost of operating a machinery and it is one of the capital budgeting method used by firms when they have to decide which machinery to operate and how much cost is going to be annually for them. The equivalent annual method is used to compare projects when the projects lives are unequal.