Question

Describe four problematic situations that will make determining incremental cash flows difficult.

Describe two incremental cash flows that will occur at the investment outlay.

Answer 1

There are various situations where determination of incremental cash flows creates problems. The first situation is separation of sunk costs from incremental costs. Many at times there are sunk costs which have already been incurred and which are irrelevant in decision making. Such costs should be distinguished from incremental costs.

The analyst must take into account all opportunity cost as incremental costs. This is the opportunity cost of the next best alternative and it is difficult to determine since there is no clear cash outflow and this is only an estimation. Determining the impact of cannibalization is another difficult situation. This is a scenario where undertaking a particular project in consideration can have a negative impact on the existing revenues of the company. The fourth and last situation is determination of allocated costs. There are various common costs which are incurred by the business and which do not belong to any particular project. The analyst must consider the allocation of such costs on a Scientific Accounting basis.

Two incremental costs that can occur initially are:1: cost of the new machine or fixed asset

2: increase in working capital required for the project.