Question

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12. You are provided a chart representing the cash flows expected from a coffee shop project in a retail store. You remember from your finance course that only incremental cash flows should be included in the chart as relevant items for capital budgeting decision. When you examine the chart, you have noted the following points. (10p) a. Comment on each as relevant or not and, b. briefly explain why in one or two sentences. The coffee shop project chart includes expected revenue increase in retail store due to opening of the planned coffee shop. The retail store owner first wanted to initiate this project two years ago and spent 100.000 Lira for a market research and feasibility report. The invoice is already paid. The chart includes this item as Initial Cash Outflow. The project uses an empty corner in the retail store. The space is currently not rented to anyone, thus no income is generated. However, it is estimated that 2.000 Lira rental income could be generated if rented. The chart includes this figure as cash outflow. 50% of the project's initial outlay will be financed by bank loan. The chart includes the costs interest) of this loan. The current overhead costs for the retail store (electricity, heating, security, etc.) is 5.000 Lira per month. The new project will not cause an increase in these costs. However, since 20% of the store space will be allocated for the coffee shop project, the accountant decides to allocate 1.000 TL (20%) of the said expenses to the new project, once it starts to operate. These expenses are included in the chart as cash outflow.

Answer 1

Answers:

1. The coffee shop project chart includes expected revenue increase in retail store due to opening of the planned coffee shop.

Ans: The above is a relevant item in Incremental Cash Flow for capital budgeting decisions. The reason being the formula for ICF.

The formula for Incremental Cash Flow is Revenues - Expenses - Initial Cost

2. The retail store owner first wanted to initiate this project two years ago and spent 100,000 Lira for a market research and feasibility report. The invoice is already paid. The chart includes this item as Initial Cash Outflow.

Ans: The above is not a relevant item in Incremental Cash Flow for capital budgeting decisions. The reason being the items included in incremental cash flows are the combination of the cash inflows and cash outflows occurring in the same time period.

Past costs are sunk costs and incremental cash flows looks into future costs.

3. The project uses an empty corner in the retail store. The space is currently not rented to anyone, thus no income is generated. However, it is estimated that 2.000 Lira rental income could be generated if rented. The chart includes this figure as cash outflow.

Ans: The above is a relevant item in Incremental Cash Flow for capital budgeting decisions. The reason being it is a opportunity cost and this refers to a business' missed chances for revenues from its assets.

4. 50% of the project’s initial outlay will be financed by bank loan. The chart includes the costs (interest ) of this loan.

Ans:  The above is not a relevant item in Incremental Cash Flow for capital budgeting decisions. The reason being discount rate used in the analysis should reflect the cost of capital. If the project is financed entirely with debt capital, the discount rate will be the interest rate charged by the lender. If the discount rate is designed to represent the cost of capital for the business project, interest expense should not be included as an operating cash flow. If it is, interest (the cost of capital) will be counted twice.

5. The current overhead costs for the rental store (electricity, heating, security, etc,) is 5.000 Lira per month. The new project will not cause an increase in these costs. However, since 20% of the store space will be allocated for the coffee shop project, the accountant decides to allocate 000 TL (20%) of the said expenses to the new project. Once it starts to operate. The expenses are included in the chart as cash outflow.

Ans. The above is not a relevant item in Incremental Cash Flow for capital budgeting decisions.  The reason being the costs associated with renting out a store is already incurred and hence Sunk Cost not relevant for incremental cash flows.