366 Part 4 Investing in Long-Term Assets: Capital Budgeting
mind is this: For capital budgeting purposes, the project’s cash! ows, not its accounting
income, is the key item.12-1b Timing of Cash Flows
In theory, capital budgeting analyses should deal with cash! ows exactly when
they occur; hence, daily cash! ows theoretically would be better than annual! ows.
However, it would be costly to estimate and then analyze daily! ows, and they
would probably be no more accurate than annual estimates because we simply
cannot forecast accurately at a daily level out 10 years or so into the future. There-
fore, we generally assume that all cash! ows occur at the end of the year. Note,
though, for projects with highly predictable cash! ows, it might be useful to
assume that cash! ows occur at midyear (or even quarterly or monthly); but for
most purposes, we assume end-of-year! ows.12-1c Incremental Cash Flows
Incremental cash! ows are! ows that will occur if and only if some speci" c event
occurs. In capital budgeting, the event is the " rm’s acceptance of a project and the
project’s incremental cash! ows are ones that occur as a result of this decision.
Cash! ows such as investments in buildings, equipment, and working capital
needed for the project are obviously incremental, as are sales revenues and
operating costs associated with the project. However, some items are not so obvi-
ous, as we explain later in this section.12-1d Replacement Projects
Two types of projects can be distinguished: expansion projects, where the " rm makes
an investment, such as a new Home Depot store, and replacement projects, where the
" rm replaces existing assets, generally to reduce costs. For example, suppose Home
Depot is considering replacing some of its delivery trucks. The bene" t would be lower
fuel and maintenance expenses, and the shiny new trucks also might improve the
company’s image and reduce pollution. Replacement analysis is complicated by the
fact that almost all of the cash! ows are incremental, found by subtracting the new
cost numbers from the old numbers. Thus, the fuel bill for a more ef" cient new truck
might be $10,000 per year versus $15,000 for the old truck. The $5,000 savings is the
incremental cash! ow that would be used in the replacement analysis. Similarly, we
would need to " nd the difference in depreciation and other factors that affect cash
! ows. Once we have found the incremental cash! ows, we use them in a “regular”
NPV analysis to decide whether to replace the asset or to continue using it.12-1e Sunk Costs
A sunk cost is an outlay that was incurred in the past and cannot be recovered in
the future regardless of whether the project under consideration is accepted. In
capital budgeting, we are concerned with future incremental cash! ows—we want to
know if the new investment will produce enough incremental cash! ow to justify
the incremental investment. Because sunk costs were incurred in the past and cannot be
recovered regardless of whether the project is accepted or rejected, they are not relevant in
the capital budgeting analysis.
To illustrate this concept, suppose Home Depot spent $2 million to investigate
a potential new store and obtain the permits required to build it. That $2 million
would be a sunk cost—the money is gone, and it won’t come back regardless of
whether or not the new store is built.
Not handling sunk costs properly can lead to incorrect decisions. For example,
suppose Home Depot completed the analysis and found that it must spend anIncremental Cash Flow
A cash flow that will occur
if and only if the firm takes
on a project.Incremental Cash Flow
A cash flow that will occur
if and only if the firm takes
on a project.Sunk Cost
A cash outlay that has
already been incurred and
that cannot be recovered
regardless of whether the
project is accepted or
rejected.Sunk Cost
A cash outlay that has
already been incurred and
that cannot be recovered
regardless of whether the
project is accepted or
rejected.