10: Cash Flow and Capital BudgetingFor example, suppose you complete your undergraduate degree, work for a few years and then
consider quitting your job to return to school to pursue an MBA degree. Many of the incremental
outflows associated with going back to school are fairly obvious, such as tuition and fees, the cost of
textbooks and, possibly, relocation expenses. What about expenditures on room and board? Whether or
not you decide to pursue an MBA, you still have to eat and have a place to sleep at night. Therefore, room
and board expenditures are not incremental to your decision to go back to school.^8
The cash inflows associated with an investment in an MBA degree are more difficult to estimate. You
believe that obtaining an MBA degree offers the opportunity to earn higher pay after graduation than you
earned before returning to school. Furthermore, you hope that, after obtaining an MBA, your salary will
increase at a much faster rate than it otherwise would. The net cash flow equals the difference in the
salary that you earn with an MBA versus the salary that you would have earned without an MBA, after
taxes, of course.
Incremental cash flows should be calculated relative to what the world would be like if the project were
not pursued. For example, one of the largest investments that companies make is acquiring another business.
In an acquisition, the bidder evaluates the incremental cash flows from making the acquisition relative to what
the bidder’s cash flows would be if the target company remained independent or was acquired by another
company. Indeed, managers often state that one of their motivations for buying other companies is to keep
them out of the hands of competitors. If a bidding company believes that its existing business would be
negatively impacted if a competitor purchased the target company, then the reduction in cash flows that a
successful acquisition prevents represents a cash inflow from the acquisition. As you can imagine, estimating
the consequences of a competitor’s actions on a company’s existing business is very difficult.
10-2a SUNK COSTS
A sunk cost is a cost that has already been paid and is therefore not recoverable; thus, it is irrelevant to the
investment decision. For instance, in the ‘Finance in practice’ example, your cash outflows did not include
the money you had already spent on the GMAT review and on visits to MBA programs. Clearly, these costs
are not recoverable, whether or not you ultimately decide to give up your job and return to school. The
money has already been spent, and therefore has no bearing on your investment decision. Simply stated,
sunk costs are irrelevant, and therefore should be ignored when determining an investment’s relevant cash flows.
10-2b OPPOrTUNITY COSTS
In the ‘Finance in practice’ box, we made a number of simplifying assumptions in our analysis of the
decision to pursue an MBA. For instance, we assumed that you received your pay in a lump sum each
year and that you faced a flat tax rate. Of course, the incremental salary that you earn arrives monthly,
and your higher earnings may be taxed at a higher rate. All these effects are easy to account for, although
the calculations become a bit more tedious.
However, there is one major error in our analysis of your investment problem. We ignored a significant
opportunity cost. Undertaking one investment frequently means passing on an alternative. In capital
budgeting, the opportunity costs of an investment are the cash flows that the company (or in this case, you)
will not receive from other investments (or actions) as a result of undertaking the proposed investment.
sunk costs
Costs that have already been
paid and are therefore not
recoverableopportunity costs
Forgone cash flows on an
alternative investment that the
company or individual decides
not to make8 Of course, you may spend more on housing and food while you’re working than when you’re in graduate school. In that case, the difference in
spending would be an incremental cash inflow.