- Cash payment for any additionalengineering or design work to be incurred if a
decision is made to invest. Care must be taken not to include “sunk costs” which
reflect cash outflows already incurred in the process of preparing for the invest-
ment decision. The relevant cash outflows are those incurred from the decision
day forward and only if the project is undertaken. - The cash opportunity cost of any existing equipment or space allocated to the
project. If a section of a factory is currently idle but would be used for the new
project, the relevant cost is the alternate cash flow that section might generate.
(Could it be subleased to another firm?) If no alternative use exists for the sec-
tion (i.e., it will otherwise sit idle), it has no cash opportunity cost. An ac-
counting allocation of overhead to departments or divisions on the basis of
floor space occupied is not a relevant cost, because it does not involve cash
flow. - Investment in additional working capital necessitated by the new project, such
as larger cash balances, more inventory, or expanded receivables. These items
might be negative (i.e., a cash recovery) if a replacement project enables the
firm to operate with less cash, inventory, or receivables. - Outlays in future years needed to supplement the original investment. Examples
are periodic major overhauls of key assets and costs incurred at the end of the
project to close it. Examples of the latter are the cost of disposing of nuclear
waste or restoring an open pit mining site to a natural state by regrading and re-
planting.
The essence of determining what cash outflows are relevant to the investment de-
cision is to look only at those future cash outflows that will take place because of the
investment decision, and to ignore both earlier cash outflows undertaken for analyti-
cal purposes (sunk costs) and accounting overhead charges which do not represent
additional new cash outflows.
(b) Project Cash Inflows. The relevant cash inflows for any project are those that
will be received by the firm in each future year from the investment. This set of cash
flows must be identified by specific year.
Each annual cash inflow differs from net income for that same period for two gen-
eral reasons:
- The cash inflows are calculated ignoring noncash expenses, such as deprecia-
tion of assets, or amortization of earlier costs, such as research and develop-
ment (R&D) or prior-service pension costs. - The calculation is usually made on the hypothetical assumption that the entire
venture is financed with equity (stockholder) funds and that taxes are thus based
upon such an “all-equity” assumption. Consequently, the income tax calcula-
tion is a hypothetical amount, unless the firm is, in fact, financed without any
debt. (The tax shelter consequences of interest payments are incorporated into
the cost-of-capital calculation.)
A simplified view of a single year’s cash flow calculations is illustrated below.
4.2 GENERAL METHODOLOGY FOR ONE-COUNTRY CAPITAL BUDGETING 4 • 3