Question

Why is it important to evaluate capital budgeting projects on the basis of incremental cash flows, what three components of cash flow may exist for a given project and how can expansion decisions be treated as replacement decisions, additionally what effect do sunk costs and opportunity costs have on a project’s incremental cash flows.

MINIMUM 350 WORDS PLEASE.

Answer 1

Why is it important to evaluate capital budgeting projects on the basis of incremental cash flows,

For any decision, the difference in cash flows between alternatives is what is relevant. It is true for capital budgeting decisions also.

One need not consider total cash flows that would occur. It is the difference between the 'cash flows with the project' and 'cash flows without the project' that should be considered. This applicable for both cash inflows and cash outflows.

If total cash flows are considered it would give a misleading picture. What is required is the effect that a project would create on the cash flows, which would mean incremental cash flows.

what three components of cash flow may exist for a given project

The three components of cash flows for a given project are:

1) Initial cash flow

2) Operating cash flows

3) Terminal non-operating cash flows

and how can expansion decisions be treated as replacement decisions,

Expansion decisions can be considered as replacement decisions relating to capacity, where lower capacity machinery is replaced by higher capacity machinery.

additionally what effect do sunk costs

Sunk costs are past costs and hence have no effect on the decision to be taken.

and opportunity costs have on a project’s incremental cash flows.

Opportunity costs are to be considered as incremental costs and hence will increase the total cash outflows and reduce the net cash inflows.